Withdraw funds with penalty or bear high management fees for 10 years?

Question

I have a friend in the following situation:

They worked with an investment manager to invest $300,000. The manager charges 1.5% of assets under management quarterly. The manager has invested all the money in high risk equity funds (mostly emerging markets). The investments have performed poorly and the account is now valued at $220,000.

I have advised my friend to stop giving more money to the manager. They have to leave the current contributions in the account for 10 more years or they will pay a penalty. I am trying to decide if they should:

1. Leave the remaining $220,000 in the account with the investment manager for 10 more years. They are able to change the assets that the manager invests in to something more reasonable.

or:

2. Take out the money and reinvest it themselves in some other fund with low management fees. They will be penalized $60,000 for doing this and will only have $160,000 to invest.

I think the main question is whether the 1.5% quarterly fee is so bad that it warrants losing $60,000 immediately.

My friend lives in Hong Kong so I don't think taxes need to be taken into consideration.

Answer 1

I think the main question is whether the 1.5% quarterly fee is so bad that it warrants losing $60,000 immediately.

Suppose they pull it out now, so they have 220000 - 60000 = $160,000. They then invest this in a low-cost index fund, earning say 6% per year on average over 10 years. The result:

160000 * (1.06)^10 = $286,536

Alternatively, they leave the $220,000 in but tell the manager to invest it in the same index fund now. They earn nothing because the manager's rapacious fees eat up all the gains (4*1.5% = 6%, not perfectly accurate due to compounding but close enough since 6% is only an estimate anyway). The result: the same $220,000 they started with.

This back-of-the-envelope calculation suggests they will actually come out ahead by biting the bullet and taking the money out. However, I would definitely not advise them to take this major step just based on this simple calculation. Many other factors are relevant (e.g., taxes when selling the existing investment to buy the index fund, how much of their savings was this $300,000). Also, I don't know anything about how investment works in Hong Kong, so there could be some wrinkles that modify or invalidate this simple calculation. But it is a starting point.

Based on what you say here, I'd say they should take the earliest opportunity to tell everyone they know never to work with this investment manager. I would go so far as to say they should look at his credentials (e.g., see what kind of financial advisor certification he has, if any), look up the ethical standards of their issuers, and consider filing a complaint. This is not because of the performance of the investments -- losing 25% of your money due to market swings is a risk you have to accept -- but because of the exorbitant fees. Unless Hong Kong has got some crazy kind of investment management market, charging 1.5% quarterly is highway robbery; charging a 25%+ for withdrawal is pillage. Personally, I would seriously consider withdrawing the money even if the manager's investments had outperformed the market.

Answer 2

Most financial "advisors" are actually financial-product salesmen. Their job is to sweet-talk you into parting with as much money as possible - either in management fees, or in commissions (kickbacks) on high-fee investment products** (which come from fees charged to you, inside the investment.) This is a scrappy, cutthroat business for the salesmen themselves. Realistically that is how they feed their family, and I empathize, but I can't afford to buy their product. I wish they would sell something else.

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These people prey on people's financial lack of knowledge. For instance, you put too much importance on "returns". Why? because the salesman told you that's important. It's not. The market goes up and down, that's normal. The question is how much of your investment is being consumed by fees.

How do you tell that (and generally if you're invested well)? You compare your money's performance to an index that's relevant to you. You've heard of the S&P 500, that's an index, relevant to US investors.

Take 2015. The S&P 500 was $2058.20 on January 2, 2015. It was $2043.94 on December 31, 2015. So it was flat; it dropped 0.7%.

If your US investments dropped 0.7%, you broke even. If you made less, that was lost to the expenses within the investment, or the investment performing worse than the S&P 500 index. I lost 0.8% in 2015, the extra 0.1% being expenses of the investment.

Try 2013: S&P 500 was $1402.43 on December 28, 2012 and $1841.10 on Dec. 27, 2013. That's 31.2% growth. That's amazing, but it also means 31.2% is holding even with the market. If your salesman proudly announced that you made 18%... problem!

All this to say: when you say the investments performed "poorly", don't go by absolute numbers. Find a suitable index and compare to the index. A lot of markets were down in 2015-16, and that is not your investment's fault. You want to know if were down compared to your index.

Because that reflects either a lousy funds manager, or high fees.

This may leave you wondering "where can I invest that is safe and has sensible fees? I don't know your market, but here we have "discount brokers" which allow self-selection of investments, charge no custodial fees, and simply charge by the trade (commonly $10). Many mutual funds and ETFs are "index funds" with very low annual fees, 0.20% (1 in 500) or even less.

How do you pick investments? Look at any of numerous books, starting with John Bogle's classic "Common Sense on Mutual Funds" book which is the seminal work on the value of keeping fees low.

If you need the cool, confident professional to hand-hold you through the process, a fee-only advisor is a true financial advisor who actually acts in your best interest. They honestly recommend what's best for you. But beware: many commission-driven salespeople pretend to be fee-only advisors. The good advisor will be happy to advise investment types, and let you pick the brand (Fidelity vs Vanguard) and buy it in your own discount brokerage account with a password you don't share.

Frankly, finance is not that hard. But it's made hard by impossibly complex products that don't need to exist, and are designed to confuse people to conceal hidden fees. Avoid those products. You just don't need them.

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Now, you really need to take a harder look at what this investment is. Like I say, they make these things unnecessarily complex specifically to make them confusing, and I am confused.

Although it doesn't seem like much of a question to me. 1.5% a quarter is 6% a year or 60% in 10 years (to ignore compounding). If the market grows 6% a year on average so growth just pays the fees, they will consume 60% of the $220,000, or $132,000. As far as the $60,000, for that kind of money it's definitely worth talking to a good lawyer because it sounds like they misrepresented something to get your friend to sign up in the first place. Put some legal pressure on them, that $60k penalty might get a lot smaller.

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** For instance they'll recommend JAMCX, which has a 5.25% buy-in fee (front-end load) and a 1.23% per year fee (expense ratio). Compare to VIMSX with zero load and a 0.20% fee. That front-end load is kicked back to your broker as commission, so he literally can't recommend VIMSX - there's no commission! His company would, and should, fire him for doing so.

Answer 3

Here's the purely mathematical answer for which fees hurt more. You say taking the money out has an immediate cost of $60,000. We need to calculate the present value of the future fees and compare it against that number.

Let's assume that the investment will grow at the same rate either with or without the broker. That's actually a bit generous to the broker, since they're probably investing it in funds that in turn charge unjustifiable fees. We can calculate the present cost of the fees by calculating the difference between:

• how much your friend has and
• how much someone else would have to have to wind up with the same amount of money investing without the burden of the fees.

As it turns out, this number doesn't depend on how much we should expect to get as investment returns. Doing the math, the fees cost:

220000 - 220000 * (1-0.015)^40 = $99809

That is, the cost of the fees is comparable to paying nearly $100,000 right now. Nearly half the investment!

If there are no other options, I strongly recommend taking the one-time hit and investing elsewhere, preferably in low-cost index funds.

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Details of the derivation. For simplicity, assume that both fees and growth compound continuously. (The growth does compound continuously. We don't know about the fees, but in any case the distinction isn't very significant.) Fees occur at a (continuous) rate of rf = ln((1-0.015)^4) (which is negative), and growth occurs at rate rg. The OPs current principal is P, and the present value of the fees over time is F. We therefore have the equation

P e^((rg+rf)t) = (P-F) e^(rg t)

Solving for F, we notice that the e^rg*t components cancel, and we obtain

F = P - P e^(rf t) = P - P e^(ln((1-0.015)^4) t) = P - P (1-0.015)^(4t)

Answer 4

To me, it depends.

How much are their total assets? Having 10% of your money in something like that isn't crazy. having it all in? That IS crazy.

Can they reduce their exposure to this account without paying a penalty (say pull out 10%?)

The Manager should be taking direction from them. If they aren't able to get the manager to re-allocate to something more suitable, under your friends direction, they should then pursue whether or not the manager is operating lawfully.