Why are management fees so bad?
Below is an example that truly encompasses the complete picture.
Babu is an executive that has a $400,000 portfolio which is expected to return 6% over the next 30 years.
He pays 2% management fee to his advisor.
1. What is Babu’s expected wealth at the end of 30 years?
2. What proportion of investment gains was paid out as management fees?
The answer to question 1 is:
(For those who are mathematically inclined, the formula is 400,000*((1.06)*(1-0.02))30)
Answer to question 2 is:
We first need to compute the ending value again by changing the management fee to 0% which we arrive at a figure of $2,297,396 which is a very large difference from $1,253,194. A difference of just over $1M!
Babu started out with $400,000, so his total gains with and without a management fee would be $853,194 and $1,897,396, respectively.
We can calculate now that the 2% management fee consumed 55% of his wealth ($1,897,396 − $853,194)/$853,194).
Below is a table breaking out the consumption of wealth by management fees. On the left side, you have the expected investment return and the top is the number of years invested. With our example of 6% return with a 30-year time horizon, indicated in red shows consumption of wealth is at 55%.
Proportion of Investment Growth Consumed by a 2% Management Fee