Hidden Costs of Investing

My career in finance was built on our collective reluctance to act on what I’m about to explain.

I know that it’s a pain to change who manages your assets. However, you give up a TON of money by not forcing yourself to choose the lowest cost provider.

How much? Let’s see if we can find out!

Active

I’m 45 years old and I want to draw down my retirement assets at 70. For each $100,000 of my portfolio, what does it cost me to use active management vs the lowest cost provider of passive management?

The table above assumes that you’re not getting (legally) ripped off. A fee/expense differential of 1.2% per annum isn’t out of the ordinary. I’ve worked with vehicles that had total fees and expenses of up to 5% per annum.

The number that should catch your eye is $131,853 OF LOST RETURN per $100,000 OF INVESTMENT. The extra 1.2% of fees means you miss out on the equivalent of 131% of your initial investment over the life of this deal.

By the way, when I help people review the true cost of their portfolios, their fees and expenses are usually more than this scenario. I know it hurts to think that you’re being ripped off but please read through to the end!

What about professional investors? They must be smarter, right?

I don’t know about smarter, but I do know that large institutions are treated very well by their managers.

Government pensions, insurance companies and high-net worth families. They have invested with the firms that taught me finance, and we did very well for them. However, we also did very well for ourselves.

We did this by offering terms called “two and twenty” – we received an annual fee of 2% of the assets that we advised and 20% of the gains that we generated. What’s that look like?

Fund

With 10 years at 7%, a passive investor would receive $195,797 for each $100,000 invested. Using the terms of a professional manager, the money back falls to $150,312 per $100,000 invested. The reduction is due to the impact of fees ($32,908) and profit sharing ($12,577).

The pros are giving away 48% of their return. I’ll leave the “why” for Michael Lewis, Taleb and Kahneman to explain.

But it gets better!

If you live in a large American state then, odds are, your state pension invests in something called a “fund-of-funds.” A fund-of-funds is an active manager that invests in “two and twenty” funds. Two sets of fees. The scale of the resulting underperformance is breathtaking.

Why does this matter to you?

Here’s why. A financial adviser that invests your money in a pool of active managers is delivering a fund-of-funds approach to your portfolio (and you’re probably getting screwed by fees).

All of this is legal and has to be disclosed to you (as investor and/or state taxpayer).

If you ask about total, look through cost of investment and your adviser starts stalling, then you have a problem. 

Also be wary when advisers produce a fee example for a “tax-free investor.” You and I pay taxes and most changes in portfolio mix have a cost to us.

TIP: The best investment you can make is knowing the true cost of your investment strategy. Get it done this week!

“Little” percentages cost you big dollars over time.

+++

Make the call and ask… “Fees, expenses, transactions costs, taxes – please tell me everything that I’m paying all the way through to the final investment.”

When you get the information, go compare to what a company like Vanguard can do for you.

How To Own The Hospital

Halfway through my first decade in Private Equity, we used this scheme to raise money for investment.

Step One: Start by creating a partnership agreement that outlines how everyone will work together.

Step Two: To show you a case study with numbers, lets assume that the hospital pays $10 million of gross compensation to the doctors. If the docs form a partnership then the partnership would have net income of $10 million.

Step Three: The docs agree that 25% of their gross compensation ($2.5 million) will be at risk for debt service. This would let them borrow between $30 and $62.5 million.

  • $30 million is $2.5 million total repayment per annum, 15 years, 3% cost of funds
  • $62.5 million is $2.5 million interest only repayment, 4% cost of funds

You could top this up with an equity investment from the docs. I seem to recall that we committed about 20% of the amount that we raised in debt. Let’s ignore that for now.

Step Four: When we used this structure we invested alongside a financial partner. In our case, this was the private equity funds that we advised.

If you were buying a hospital then you might want to have the hospital administration as part of your partnership.

Your partnership could joint venture with a deep-pocket financial partner (private equity fund or insurance company) or an operating partner (hospital management company).

This could double the amount of equity that you had available and take you to $60 to $125 million.

Step Five: Depending on the cash flow strength, and asset structure, of the hospital you are acquiring, you might be able to raise debt that is 2-4x the value of your equity investment.

That gives a range of $180 to $600 million total deal size.

I wonder if there are restrictions on leverage for hospitals?

Step Six: Keep doing what you are already doing.

When we used this structure:

  • We invested in a range of deals, rather than a single business
  • Debt was recourse against the partnership, but not the partners. Putting this in context of the above example – the bank that lent the money to could come after your medical practice but couldn’t come after the doctors
  • Proceeds from the deals (dividends and capital gains) were sufficient to cover the cost of partnership debt service. Putting this in context – structured properly, the hospital investment generates enough cash flow so doctor compensation stays the same

Step Seven: Run the hospital to pay down debt and generate cash for the doctor’s investment vehicle.

The structure came about because the partners realized that the assets (in our case investment funds) were useless without the investment team.

The deal we did was part of a restructuring that enabled the workers to control their means of production.

Nobody mentioned the irony.