T-REX SCORES: TRUTH AND DINOSAURS
Most investment fees are quoted (if they are quoted!) as a percentage of the amount invested. So, a fund with 2 percent fees will cost you 2 percent of your total investment annually. This method of quotation is highly misleading for three reasons.
1. Fundamental to any economic transaction is a cost–benefit analysis. Whether buying a cup of coffee, a new car or a new home, or paying for a service like a carwash or high-speed internet connection, an engaged consumer compares the potential benefit offered against the price to be paid. Consciously, or probably more often subconsciously, consumers ask themselves the question, “Is the cost fair compared with the benefit offered?” There is no reason investing should be any different. The benefit you are seeking is to earn a return on your investment. Quoting the cost as a percentage of that return would provide a more accurate representation of the cost versus the benefit received. Of course, you can’t accurately predict future investment returns, but you can use reasonable projections. For example, you might project a one-year total investment return of 6 percent. In this case, a fee of 2 percent of the total amount invested would consume 33.3 percent of the projected benefit. The same fee would consume 25 percent of an 8 percent pre-fee investment return. So you can conclude that, assuming a pre-fee investment return of 6 to 8 percent, the cost of the product is somewhere between 25 to 33.3 percent of the total benefit over one year.
2. When a product will be owned for years or decades, quoting the fee as an amount owing over an arbitrary fraction of that time frame (that is, one year) makes no sense. For example, a thirty-five-year-old looking to invest for a long retirement stretching from age sixty-five to age ninety-five might use a fifty-year average investment horizon, while a couple saving to finance a newborn’s post-secondary edu- cation might use a twenty-year average horizon. Quoting an annual fee doesn’t tell you much about the total cost over what is typically a multi-decade investment time frame. Providing an estimate of the total fee on the basis of your projected investment horizon would be much more revealing.
3. When you pay investment fees, you lose twice. You lose the fee and you lose some of your compounding magic. Annual fee quotations give no indication that your ‘compounding loss’ accelerates as the years pass.
I have developed a much more revealing way to measure the impact of fees on your investments: simply project how much of your total investment return you actually get to keep after fees. This method of demonstrating the impact of investment fees, which I call the ‘Total Return Efficiency Index Score’ or ‘t-Rex Score,’ addresses the three shortcomings of the conventional fee quotation.
1. compare cost (fees) versus benefit (gain)
2. allow for a wide range of time frames
3. fully capture the ever-growing compounding loss
Your t-Rex Score will tell you how efficiently the returns on your underlying investments translate into returns for you. The higher your t-Rex Score, the more of your investment return you get to keep.
You will find the t-Rex calculator at www.larrybates.ca. Assuming you know the full amount of all investment fees you are paying, it’s very simple to project your score. The required inputs are:
• investment amount
• projected average annual return on underlying investments before fees
• annual fees
• projected life of investment (time horizon)
Here are some sample t-Rex Scores with various time periods and annual fees, assuming the underlying investments produce an annual return of 6 percent:
Table 3.4: Sample T-REX Scores
Underlying Asset Return: 6 percent annually
Years 0.00% 0.25% 1.00% 2.00% 3.00%
1 100% 96% 83% 67% 50%
10 100% 95% 80% 61% 43%
20 100% 93% 75% 54% 37%
30 100% 92% 70% 47% 30%
40 100% 90% 65% 41% 24%
Every investor pays fees but, just for illustrative purposes, if you were to pay no fees at all, your t-Rex Score is 100 percent regardless of your time horizon.
If you pay annual fees of 0.25 percent, your t-Rex Score over twenty years would be 93 percent. In other words, you would keep 93 percent of your total gain, while the amount lost in fees (your ‘tRue fee’) totals 7 percent of your gain. So, the score is:
You: 93 percent
Bay Street: 7 percent
With a 1 percent annual fee, your twenty-year t-Rex Score falls to 75 percent and, correspondingly, your true fee jumps to 25 percent. An annual fee of 2 percent over twenty years produces a t-Rex Score of 54 percent and a tRue fee of 46 percent, while the same 2 percent annual fee results in a forty-year t-Rex Score of 41 percent and a tRue fee of 59 percent.
As you can see, the higher the annual fee and the longer the time horizon, the lower your t-Rex Score (and, of course, the higher your tRue fee).
Very long investment time frames (which are now very realistic, given increased life expectancies) combined with high fees produce t-Rex Scores well below 50 percent.
Your T-REX Score
Regardless of the nature of your current investments, or any new investments you may be considering—even if you are confident you know the full extent of fees you are paying—I urge you to make the following request of your investment provider:
“I need to get a complete and clear picture of the investment fees I am, or may be, incurring. Please provide a full summary of all investment-related fees and charges that are or will be either paid to, or deducted by, you, your firm, any underlying fund manager, and any other party involved. Please provide fee details both in terms of current dollars and percentage of my total investments. Thank you.”
Don’t be satisfied until you receive and fully understand this summary!
Once you are sure you know how much you are paying in annual fees, calculate your own t-Rex Score using a variety of scenarios to get a feel for how much of your investment gains you will actually get to keep. Once you know your t-Rex Score and have gained a better understanding of investment basics through reading this book, you can judge whether the services you are receiving—which may include advice on investments, retirement planning, insurance, estate planning, tax, etc.—are worth the price you are paying. If you conclude that you are keeping your fair share of your returns, good for you! If not, you need to switch to Simply Successful Investing!
You can learn more about the math behind t-Rex Scores at www.larrybates.ca.
Mutual Fund T-REX Scores
What happens in the fund business is that the magic of compounding returns is overwhelmed by the tyranny of compounding costs. It’s a mathematical fact. – Jack Bogle, founder of the Vanguard group.
Your t-Rex Score will demonstrate just how tyrannical fees can be, particularly if, like the majority of Canadian investors, you invest in mutual funds.
Mutual fund managers claim their skill will result in superior investment returns over time, but stacks of academic and industry studies overwhelmingly prove otherwise. Despite this track record of underperformance, millions of Canadians own mutual funds. In fact, according to the Investment Funds Institute of Canada (IFLC), as of December 2017, total Canadian mutual fund holdings amount to a staggering $1.48 trillion. IFLC reports that 86 percent of Canadians have greater confidence in mutual funds than in other financial products, such as GICs, bonds, and stocks. But do mutual fund investors know the score? Do they understand how much of their investment gains they actually get to keep?
Index ETF T-REX Scores
There is a better way: Simply Successful Investing! One of the three methods of Simply Successful Investing is Assemble-It-Yourself (AIY), and investing in select index ETFs will likely provide pre-fee total returns similar to mutual funds but leave much more in your pocket with T-REX Scores in the 90s! AIY investing will be detailed in later chapters but consider this: assuming equivalent pre-fee investment returns, an index ETF with a T-REX Score of 90 percent will produce double the net gain of a mutual fund with a T-REX Score of 45 percent. Simply by switching from high-cost mutual funds to low-cost index ETFs, millions of Canadian investors have the potential to double the investment gains they actually get to keep!
Note that this potential doubling of returns is not based on luck or skill or dazzling performance by a genius stock trader. The potential to double your returns compared to the average Canadian mutual fund investor is driven simply by paying lower fees.
Before you make any investment, clearly understand both the total amount of fees you will be charged, and the full impact of those fees over time. Know your t-Rex Score!