Principles of Finance: Unit 2, The Math of Fees

So what's the math involved when figuring out fees? How much cash should a mutual fund have on hand? You've got questions - we've got answers.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:20

range of investment vehicles without having to invest like eighteen

00:24

billion dollars in a jillion different stocks to do so

00:27

well Second mutual funds exist because well there was a

00:30

time in history when actively managed funds handily beat the

00:36

passively managed or unmanaged world of index funds or the

00:40

stock market and they beat it by a wide enough

00:43

margin that the spread more than covered the fees and

00:46

taxes that the mutual fund industry charge But well that

00:51

isn't true anymore in today's fastly more competitive than the

00:54

world of nineteen sixty eight world So why do people

00:59

still invest and actively managed mutual funds Good question there

01:04

weeks psychology They need the emotional hand holding When the

01:07

market has a bad hair day they didn't watch shmoop

01:11

well they're fund broker and gave them that awesome front

01:14

row said a seats at the n b a game

01:17

Last saturday night and well they didn't do the math

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on just how much those tickets actually cost them over

01:22

the next twenty years is paid fees on mutual funds

01:26

broker sold them well we really don't know why people

01:29

invest in managed funds anymore it's pretty much a dying

01:32

industry today there's almost nobody ever in any five or

01:36

ten year period of time who after fees and taxes

01:40

beats index funds Why Well a bunch of reasons the

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biggest is that funds have to fight hard for what's

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called shelf space yet like in a grocery store but

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it's in a stock brokerage to get sold through broker

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channels or other places where people buy mutual funds and

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that costs money so small funds get ignored and there's

01:59

always a lot of pressure for mutual funds to get

02:02

bigger so they can charge more fees and pay more

02:04

for distribution Well the best way to get bigger would

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be to just have superior performance and let your numbers

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do the talkin right Like michael phelps doesn't have to

02:13

pound his chest about how great a swimmer he is

02:15

right Why Well you can't see his chest it's covered

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With a whole bunch of olympic gold medals there yeah

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so funds spend a lot of resource is trying to

02:26

get bigger marketing wise rather than better investing wise and

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they do try to be better They're sincere they work

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hard They all want to be one flavor or another

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of the michael jordan of investing who's named warren buffett

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in real life Unfortunately for the mutual fund industry however

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well they have all kinds of ugly headwinds in their

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face One big headwind comes in the form that mutual

02:51

funds have to hold back a certain amount of cash

02:54

because well just in the wrong time Retail investors like

03:00

you know mon pa kettle well they redeem their mutual

03:03

fund shares I'ii sell them and they put the money

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in the mattress Historically most mutual fund redemptions come near

03:10

the bottom of these ugly bear markets right at the

03:13

time when investors really will have wanted to start investing

03:16

or then getting them exposed to mutual funds and high

03:19

risk rather than taking all the risk off the table

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So mutual funds always have to carry a meaningful amount

03:26

of cash like five or ten percent in case those

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redemption suddenly hit but if you step back a little

03:32

bit lou that's too far there that's better Alright well

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overtime markets go up on average growth index is go

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up eight to ten percent a year So with dividends

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reinvested over long periods of time so just the fact

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that a mutual fund might need to keep say ten

03:49

percent cash in a world going up but ten percent

03:53

of years to get the math easy here Well that

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mutual fund by being required to carry cash is losing

03:59

one percent a year in performance and that's just the

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g rated problem The pg thirteen problem is that mutual

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funds are relatively expensive A typical index fund might charge

04:10

half a percent a year to manage your money or

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a whole lot last The big ones like spy charge

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more like point two percent And just so we're sure

04:18

you have the decimals Right That is for each hundred

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dollars you invest in spy run by vanguard You pay

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twenty cents a year right Like a little less than

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two cents a month for managing your hundred bucks Pretty

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cheap and analogous Mutual fund would cost one hundred basis

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Points more than that i e one percentage point or

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more like two percent three percent and many mutual funds

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carry up front loads or commissions paid to the broker

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who got you those nice and tickets what's the most

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species mutual funds market themselves as no load funds which

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is a complete darth vader resc joke Darth doesn't tell

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jug so this is no joke either so we're dividing

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load with commission and no load funds Well no load

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means roughly this Instead of charging you a load to

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get into the fund we're going to charge you one

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and a half percent a year for managing your money

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forever So do the math If you remain to fund

05:15

holder for twenty years from attacks perspective it's very expensive

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to ever sell a fund more on this soon In

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more videos you'd have paid one point five percent in

05:24

fees for twenty years and the fees or set based

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on the amount of money you have So as the

05:29

market goes up and the value of your investment goes

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up while you get charged mohr generally speaking meaning that

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if you started with ten grand and were charged one

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hundred fifty bucks a year to manage that money Well

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when it doubled to twenty thousand dollars eight years later

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you're charged three hundred dollars a year to manage it

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Why when it doubles again forty thousand eight years later

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and here your charge six hundred dollars to manage it

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and that fund might have the exact same basket of

05:54

stocks which all went up about the same amount here

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after year but now it costs you six times as

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much for the privilege of having those same stocks you

06:02

coulda bought yourself all right We'll compare this with a

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load fund load funds charge Ah hi fi if you

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invest on ly very small amounts of money largely because

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the paperwork and add wins expensive to manage but by

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the time you're investing ten thousand dollars well loads are

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usually pretty low like two ish percent but then the

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annual fee is more like zero point seven percent So

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if you do the math from above yes you get

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hitting your one with that commission or load And yes

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it cost you a relative bundle if you sell after

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only a year or two but if you're like ninety

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Eight percent of the world and hold your fund for

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over five years in a very large percentage Hold it

06:41

over twenty years Well any of more than made back

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the no load gimmick and then some Well But all

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of this pales compared with the fees charged by index

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funds which are almost entirely no lo and almost always

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way last than half the annual fee of manage funds

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and so on But we're moving on here Here's the

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r rated problem with managed funds versus unmanaged funds taxes

07:06

managed funds manage That means they buy and sell stocks

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They sell the winners and they buy the losers While

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each time of fund recognizes a gang sells an investment

07:17

for a profit the fund shareholder gets taxed Let's make

07:21

up a prototypical fund here it realizes gains in two

07:24

ways Short term and long term well short term gains

07:28

are gains garnered inside of one year long term means

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they held the investment over a year and then sold

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it you The shareholder in the fund gets taxed both

07:38

ways as well of course and short term gains generally

07:41

must be distributed back out to shareholders in the form

07:44

Of an annual gain on which investors ben pay ordinary

07:47

income tax so for fund is twenty percent of their

07:50

gains realized and they are short term gains in a

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typical investor pays thirty five percent marginal tax on that

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game Which berries on your region I it'll be more

07:59

in california new york and less in wyoming taxes are

08:02

a big headwind managed funds have you got all this

08:05

together and you have a one percent headwind from having

08:08

hold cash Another fee headwind of another center too Got

08:12

a whole lot of realized gain headwinds from taxes and

08:15

all that stuff Well then yes index funds and etfs

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which are very similar Well they do realize gains every

08:21

now and then but they realize that very small for

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action of the gains that mutual funds realized because index

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funds and e t s realized gains simply to re

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balance the portfolio not to make investing beds all right

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And lastly empirically there's almost no difference from manage funds

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and index funds in actual performance that is manage funds

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don't beat the market In fact most index funds outperformed

08:47

managed funds almost any way you slice and dice the

08:50

data So ah market alfa or market intelligence well just

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doesn't exist anymore certainly not the way it did in

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the nineteen sixties Anyway those were all the r rated

09:00

investment fee situations you just have to know about But

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now how about some triple x Alright hey hold your 00:09:06.962 --> [endTime] horses This isn't shmoop after dark