Wednesday, December 14, 2011

A Better Way to Explain Investing Costs

The typical person will invest for many years, but we express investment costs with yearly percentages that are misleadingly low. I propose that for recurrent costs that accumulate, we use an investing horizon of 25 years to express these figures.

For example, instead of talking about a fund's MER, we would talk about its MERQ (Management Expense Ratio per Quarter century). This would give investors a better feel for the effect of recurring costs. In another example, if an investor's portfolio concentration creates a drag on returns, we should look at the effect over 25 years rather than just one year.

In a recent article, Jonathan Chevreau observed that Investors Dividend A Fund has an MER over 2% higher than that of iShares Dow Jones Canada Select Dividend Index Fund (XDV/TSX) despite the fact that they have substantially the same holdings. Even if we add 1% to the MER of the iShares ETF to account for the cost of advice as Canadian Capitalist suggests, the percentages are 2.69% vs. 1.53%. The difference in these percentages doesn't seem like much, but if we look at MERQ (plus the cost of advice for XDV), we get 49% vs. 32%. This is a more meaningful comparison. Would you rather give away half of your money to Investors Group or one-third of your money to iShares and an advisor?

If you can handle your own investments, then you only have to give iShares 12.4% of your money over 25 years. Going even further, the MERQ of Vanguard's Total Stock Market ETF (VTI) is only 1.73%. Seeing cost figures ranging from under 2% up to 49% ought to make investors think.

In another example, I recently concluded that a portfolio of 20 randomly-selected stocks would underperform the index by 0.51% per year based on a paper by Meir Statman. If the stocks owned by dividend investors are no better than random, then a 20-stock portfolio would lose 0.51% per year to the index due to increased volatility. Based on some of the comments on that article, it seems that investors are unconcerned about such a small percentage of drag. But, if we say that the drag (dragQ?) is 12% over 25 years, it seems more troubling. Of course, most dividend investors don't believe that their stocks are no better than random, but that's a discussion for another day.

Even if the world doesn't like the idea of adding a "Q" to the end of MER and other measures, I think the fundamental idea of taking a longer view would help investors.

9 comments:

  1. I think it's a good idea, but you should take it a step further and avoid percentages. Create a "standard porfolio" measure, something like $50k starting with $10k/yr contributions over 25 years with a 6% fee-free rate of return, then say "this fund will cost the 'standard portfolio' $X."

    So running with these examples:
    The standard fee-free portfolio would be worth $710k. The XDV would cost $57.6k; the XDV +1% for advice would cost $152.5k; the IG Div A would cost $243k. Put that on a sticker on every brochure, give me my nickle for each one, and watch 10-20% of people actually clue in and switch!

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  2. @Potato: I like your idea, but the assumed rate of return part makes it somewhat tricky. Regulators would have to mandate some expected rate of return for this kind of reporting. This is doable, though.

    I'm hopeful that even if we stick with percentages, people would understand figures like 32% and 49% well enough to see that they are paying a lot of money.

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  3. @Michael - They do - 5%. You can see it in any prospectus for a mutual fund under the section "Fees indirectly borne by the investor". They take $1,000 and break down the dollar cost over 1,3,5 and 10 year periods.

    Your method is much more sensible to the average investor. (Which is why it will never get adopted unfortunately).

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  4. @Preet: I guess using 5% returns over 1, 3, 5, and 10-years periods is better than nothing, but the $1000 figure is nice and low so that the cost figures won't look scary.

    I'm not overly concerned about what methods are adopted for fund reporting. Sales and marketing people will always find a way to take the emphasis away from bad news. I'm looking for ways to give investors an accurate picture of costs. Then people who are inclined to help others can use these better pictures.

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  5. 25 years is too long, and MERQ does not convey the negative effects of high expenses in the same way as a 10 year measure, the MER Decade Equivalent. ;)

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  6. @MCMatterson: If the typical investor starts investing at age 35 or 40, it seems to me that the investing horizon is more than 25 years. I chose 25 years because it feels like a round number and it lent itself nicely to using a "Q".

    A MER Decade would be an improvement over a one-year MER, buy I don't understand why you think it would do a better job of conveying the negative effects of high expenses than MERQ.

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  7. @MCMatterson: Oops! Memory of my French classes just kicked in! MER Decade would indeed convey a different message :-)

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  8. Great article. Alas MERs aren't the only frictional costs that slowly grind away investor returns. For more see this somewhat dated piece, http://www.bylo.org/affordmf.html

    I'm biased of course but a picture is worth a 1,000 very loud words on this issue ;)

    http://www.bylo.org/merosion.gif

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  9. @Bylo: That's a good post and I like your chart. I've made a few pictures myself over the years, but I'm always looking for new ways to explain MER costs in a way that helps people underdstand them:

    http://michaeljamesmoney.blogspot.com/2009/12/mer-drag-on-returns-in-pictures.html

    http://michaeljamesmoney.blogspot.com/2008/11/mer-death-by-thousand-cuts.html

    http://michaeljamesmoney.blogspot.com/2008/05/mer-gift-that-keeps-on-giving.html

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