The other day I saw a tweet from Ankur Nagpal that if you choose to invest $5.5 million dollars from ages 35 to 60 with an active manager charging 1.5% a year, you’ll have $14 million less than if you just invest in a low cost exchanged traded fund (ETF) like Vanguard over the same time period. While it’s interesting to debate the merits of Active vs Passive management, this blog post will focus on the math behind why ETFs tend to outperform active managers over long time horizons. I will recreate Ankur’s analysis and include it as a free spreadsheet template for you to download so you can plug in your own numbers and simulate your investments over time.
Please note that nothing in here is investment advice. It is merely an academic exercise in building a spreadsheet to calculate the performance of ETFs vs Active managers over time.
The root of the analysis lies in the fact that ETFs tend to have way less fees than Active managers. Ankur’s tweet really highlighted this point. And while that is what the analysis I built will conclude, I want to mention that it’s a very one dimensional exercise. While more and more people are moving to ETFs, due to the fact that it’s much harder to beat an ETF’s return when you account for the active manager fee, I think there are still merits behind hiring a financial advisor. Good financial advisors can help you create a more bespoke investment strategy that fits your goals more. For example, someone who needs to invest their money for only 3 years may need a more tailored solution than a ETF, which generally performs well over longer periods of time. Financial advisors can also help with tax planning and your personal financial situation, for example if you have businesses and other assets. Most importantly, the best financial advisors, vastly outperform ETFs, especially when you adjust for risk.
Ankur’s Scenario: Wells Fargo vs. Vanguard ETF
Imagine you are a 35-year-old investor with $5.5 million in cash to invest until you are 60:
You have two choices:
- Invest with Wells Fargo, which charges a 1.5% annual fee.
- Invest in a Vanguard ETF with an annual fee of just 0.08%.
Both investment vehicles grow at the same exact rate over the next 25 years. Which is better? Here’s how I recreated his analysis to get to the answer.
First, I created a section use to be able to toggle the main inputs for this analysis: the starting investment amount, the active manager annual fee, the passive manager (ETF) fee,Active Manager Annual Return, and Passive Manager Annual Return.
To perfectly recreate Ankur’s analysis, you’d plug in the following:
Then, I built the actual analysis. I created a column for Age, AUM Active Investor, Active Investor Fees, AUM ETF, and ETF Fees.
For age, we are starting at 35 and then creating a new row until we get to age 60.
For AUM Active Investor and AUM ETF for age 35, we need to start with the starting investment. In my spreadsheet that’s just =B1.
For Active Investor Fees, I just multiply the AUM by the Active Mangager Annual Fee. In my spreadsheet that’s in cell B2 and my formula is just =B9*$B$2.
The next step is to figure out compound growth, with the fees included. To calculate that, you need to take the AUM from the prior year, subtract the fees, and then multiply the answer by 1 plus the growth rate. In Ankur’s example, he was growing both the Active manager and the Passive manager at 9% a year. In your analysis, you can choose to toggle these assumptions to see what happens if the active manager outperforms the passive investor. This is what the formula looks like.
Now we can just drag the formulas down and you’ll see that after 25 years, you would have paid the Active Investor $5,987,260 in fees and the ETF $405,087 in fees. This means that you would have paid $5,582,172 more in fees to the Active Investor.
You’ll also see that by age 60, you’ll have $32,503,558 in your active investor portfolio account and $46,487,455 in your ETF account. In other words you have $13,983,897 more if you chose the passive ETF under this scenario.
The next question may be, how is it possible that I have $13,983,897 less in my account if I only paid $5,582,172 more in fees? The answer lies in ‘compounding.’ The higher fees don’t just eat into annual returns; they compound over time. Every year the annual return on the active investor account starts at a lower amount than the passive investor because there have been more fees taken out of it. Every dollar spent on fees is a dollar that doesn’t compound. Over time, this creates a significant drag on portfolio growth.
How you can play with this spreadsheet template
The debate between active and passive investing isn’t just about fees. It’s about aligning your strategy with your goals, risk tolerance, and time horizon. For most investors, ETFs offer a straightforward path to long-term success, but for some, it’s not bespoke enough for their financial situation. Furthermore, if you find a manager that can outperform the ETF, the answer can be very different. For example if your active manager outperforms the ETF by 4% over the 25 year period you’d end up with a lot more money, despite paying more to the active investor. This example shows if the active investor generated 9% IRR while the ETF only generated 5%.
