Compounding returns over the long run

“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't, pays it.” 

Whether or not Albert Einstein said this doesn’t change the truth of the quote. However, for the purposes of this post, instead of focusing on compound interest, we should focus on the more general compound returns, of which interest may be just one component. The key point is there is an exponential feature to returns i.e. If it takes seven years to double your initial money at a given rate of return, it will take 14 years to increase your initial wealth four times (two doublings), 21 years to increase it eight times (three doublings), 28 years to increase it 16 times (four doublings) and so on, until we get extremely large multiples (a 10 per cent return p.a. compounded monthly over 30 years will see $1,000 grow to almost $20,000).

The effect of fees on compounded returns

Like returns themselves, fees also compound. What is not immediately apparent is that the effect of fees not only depends on the fees themselves, but also the pre-fee returns of the investment. Higher fees as a percentage of FUM create a higher fee drag over time, but a given fee at a higher annualised pre-fee return can also significantly detract from ending wealth. For example, at 50 bps annual fee (or 0.5 per cent), we typically pay away much more in fees over a 30-year horizon on an equity ETF exposure than we do on a bond or cash ETF exposure (given the expected higher rates of return equities should earn compared with bonds or cash). Specifically, at a management fee of 0.50 per cent p.a., $1,000 invested at a pre-fee return of 2 per cent p.a. would see $188 of fees paid out over 30 years, while the same amount invested at a pre-fee return of 7 per cent p.a. would see $1,125 foregone.   

The implication is also that fund managers receive far more revenue on high return products than low return products for a given management fee. It’s worth remembering that fees on their own are not everything, and that risk-adjusted after-fee returns are more important. However, for vanilla, broad-based market cap-weighted index exposures where pre-fee returns will not vary significantly between competing products, fees can be a crucial product differentiator.

The effects of inflation and implications for purchasing power over long horizons

If we are investing to fund our retirements, we need to be aware that inflation erodes the purchasing power of nominal dollars over time. This means we require our investments to, at the very least, exceed inflation to maintain the real value of our capital.

Inflation is measured by annualised changes in the consumer price index (CPI), which captures a typical basket of goods and services for Australian households. It is also worth noting that the RBA has an inflation-targeting objective and will typically adjust monetary policy to keep core inflation between 2 and 3 per cent per annum over time. However, when looking to fund retirement it is important to remember that the basket of goods and services may not be reflective of your consumption needs at retirement and inflation rates of such a basket may be higher than the CPI. Over a 30-year period, a 2 per cent p.a. rate of inflation erodes the purchasing power of $1 to $0.55, 3 per cent p.a. erodes purchasing power to $0.41 and 4 per cent p.a. inflation erodes it to $0.30.

Understanding how inflation erodes purchasing power over time is vital, but it’s also important to have a broad understanding of the long-term inflation-adjusted returns of various asset classes. What’s often safe and stable in the short term, such as cash and short-term bonds, could significantly undermine real purchasing power in the long run. Conversely, what’s often risky in the short-term, such as equities, may be the safest asset for growth and preservation of purchasing power. From March 1990 to June 2018, Australian inflation has averaged around 2.5 per cent p.a., resulting in inflation-adjusted returns for cash, long-term Australian bonds and Australian shares of 2.9 per cent p.a., 6.2 per cent p.a. and 7.1 per cent p.a., respectively. Put another way, $1,000 invested in 1990 in cash, long-term Australian bonds and Australian shares would have grown real purchasing power about 2.2 times, 5.4 times and 7 times, respectively.

Putting it all together

Compounding affects many aspects of our investing lives, both in positive and negative directions. Once we understand the power of compounding on returns and how inflation and fees compound in a negative direction, we are far more informed in constructing portfolios to support our retirements, maximise returns or to simply preserve capital.

Chamath De Silva is a portfolio manager at BetaShares ETFs