The Angels’ Share

The next time you sit down for a wee nip, think about how much your active managers are charging.

As a whisky (whiskey here in the States) matures, it loses about 2% of its volume to evaporation each year.  Distilleries call this The Angels’ Share.  They fill oak casks with a precious liquid knowing that each year part of their hard work will simply disappear.  I can’t help but think of the angels’ share when I look at expense ratios.  An investor sets aside a certain amount of money, let’s say $100,000.  They pay a money manager to invest that money – I’ll use the S&P 500 as an example.  When the investor looks at their statement, they should see that their investment returned the same amount as the index, less whatever the expense was, right?  Looking at the annualized returns, yes, that’s approximately right.  Looking at actual dollars, we see something different.  A portion of the returns evaporates, escaping the pockets of both investor and money manager.

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This chart shows the returns for the S&P 500 over the last 10 years (ending 8/31/2016, including dividends) and how much a $100,000 investment would have been worth at the end of those 10 years.  It shows returns for the S&P 500 with no fee, a 0.05% fee one might see in an ETF, a 1.00% fee one might see from an active manager, and a 2.00% fee one might see at a hedge fund (hedge funds and private investments usually also come with an incentive fee for the manager, but we’ll skip that for now).  Here’s how much money an investor would have had at the end of 10 years (ending 8/31/2016), starting with an investment of $100,000:

0.00% fee      $206,280.90 (7.51% annualized)

0.05% fee      $205,252.00 (7.46% annualized)

1.00% fee      $186,650.40 (6.44% annualized)

2.00% fee      $168,887.60 (5.38% annualized)

The higher the fee, the less money the investor kept and the lower the return.  Nothing surprising there.  What happens if we look at what makes up the gap between the benchmark and each fee in dollar terms?

A fee of 0.05% would have generated about $644.38 in fees over the last 10 years, but there is a $1,028.85 gap between the two ending values!  $384.48 evaporated.

A fee of 1.00% would have generated about $12,213.13 in fees over the last 10 years, but there is a $19,638.00 gap between the two ending values!  $7,424.87 evaporated.

A fee of 2.00% would have generated about $23,101.63 in fees over the last 10 years, but there is a $37,420.55 gap between the two ending values!  $14,318.92 evaporated.

Over the last 10 years, the expense ratio only accounted for two-thirds of the difference of the actual dollars an investor would have gotten back.  The other third went up in smoke.  What gives?

The angels’ share of investment expenses might be more accurately called opportunity cost.  Every dollar that goes to pay a money manager is a dollar that isn’t put to work for the investor and over time that evaporation compounds.  It’s just another reason to keep a sharp eye on expenses.  You can’t always rely on annualized returns to show the whole picture.