So I read an interesting blog post on Noahpinion today, regarding whether ’tis better to ditch active fund management (e.g. follow Jack Bogle’s advice and stick with index-tracker ETFs, which charge very little fees), or to save more, in terms of retirement savings. The article gets a bit economist-like, involving some basic utility functions and the like, to come up with a tentative ‘better to ditch active management’ conclusion. The short blog post + comments are worth a read.
Anyway, this got me thinking. And when I get thinking, I get modelling. So here’s a spreadsheet which models the analysis I think of, when considering this problem. Method:
- Hypothesis: I think the time spent figuring out asset managers (whether passive or active) is probably about the same as creating a basic budget. The latter allows for increased savings. So let’s find out whether time is better spent ditching active management for passive, or creating a budget, in terms of accumulated retirement saving.
- Data: for simplicity, I use the total returns of the S&P 500, data which comes from Aswath Damodoran.
- Assumptions:
- Starting salary of $50,000.
- A savings rate, without budget, of 5% p.a.
- Salary growth of 2% p.a., which is reflected in increased savings (i.e. we save 5% of the new, higher salary).
- Performance drag of active management over passive of 2% p.a. So I assume active managers under perform a passive S&P 500 fund by 2% each year.
- Budgeting increases savings by 3% p.a. So a person who currently saves 5% p.a. can up that to 8% p.a. by making a budget.
- Results:
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Budget or bin the manager? Source: Damodoran Data.
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- A Monte-Carlo simulation of 100 lifetimes (44 years of accumulated saving), randomly choosing years of S&P500 returns with replacement, brings the above picture.
- Each run charts the net benefit, in terms of wealth at retirement age, of choosing to budget rather than switch the active manager for passive. See the worst line there? That’s happened because the luck of the draw meant lots of good years for the S&P 500 portfolio: in that case having the fee drag is a really bad thing versus just saving a bit more (however you’d be very rich in either case).
- It turns out the ‘break even’ is around 4% for budget savings to exceed fee savings. So if the savings ratio can be bumped from 5% to 9%, in this example, better to budget.
- In brief: just choose the method that saves more. Unless your budget increases your saving by a fair bit more than active fees (2% in this example), focus on active fees first.
- In Noahpinion’s favour, one of his problems with this type of conclusion is that, because we can’t know how much more $1 today means to someone than $1 at retirement, we can’t use phrases like ‘better off’ to characterise the result. All we can say is the wealth is higher at retirement.
- Go ahead and play with the assumptions and see the accumulated benefit on the line chart, if you like!
In sum: suppose you’re holding some actively managed mutual funds, and are considering dumping them all for passive ETFs to save on fees, or even whether to dump one manager/ETF for another. Before spending time with the withdrawal forms and whatnot, consider creating a simple budget to increase your savings. The latter may pay off more in future.
financialpiggy 