One of the biggest realizations that I had when I first started my investing journey is the huge impact that small changes have over the long run. I don’t think I’m alone on this one. The compounding effect (or how things ‘stack up over time’) is counter-intuitive and relatively easy to underestimate. In this entry we’ll get our hands dirty and estimate the impact of TER and taxes on long-term ETF returns.
We’ll use the S&P 500 Total Return in index as a benchmark. What’s the difference between a price index and a total return index?
- A price index, e.g. the ‘normal’ S&P 500 often quoted in the news, doesn’t consider dividends
- A total return (TR) takes into account the dividends, which are assumed to be reinvested into the index.
Over the long run (say the ~30 years in our scope), the effect of reinvesting dividends is huge. Just look at the chart:
Data source: Yahoo finance
The difference in CAGR is abysmal:
|S&P 500||CAGR since 1988 (%)|
|Total return index||11.2%|
We’re using a TR index for this analysis because:
- It captures better the return you get as an investor
- We’ll consider dividend taxes later on in the analysis. A TR index allows for an apples-to-apples comparison
Our benchmark is ready. What is the impact of TER and taxes on long term returns?
Impact of TER on ETF returns
Unfortunately, we can’t fully replicate the returns of the S&P 500 TR index. Even if we reinvest dividends. Why? Because an index is a mathematical construction. We can’t buy an index. What we can do is invest in an ETF that replicates an index. This carries a cost, though. We have to pay for the management fees and additional expenses (trading, legal, auditor fees etc.) of the fund. All these expenses are captured in the ETF’s total expense ratio (TER).
TERs can be as low as ~0.05% (or 5 basis points or ‘bps’ ) for the biggest, cheapest ETFs. This one from Vanguard is a good example. ETFs on less popular indices, or those offering especial features such as currency hedging, are typically in the 20-60 bps range. TERs can also be as high as 1-2% for actively managed funds.
You might think that all these numbers are small enough not to care. But that’s far from true.
TER and index returns
TER charges are a recurring expense. They’re a small, yet continuous leak on your portfolio. This leakage compounds year after year and becomes very substantial over the long run.
Because the leakage is amplified over time, relatively small changes in TER can have devastating effects on the performance of your portfolio. Let’s see what happens to the performance of the S&P 500 TR under various TERs:
Notice the differences in CAGR:
|TER (%)||CAGR since 1988 (%)|
As you can see, TERs essentially decrease the CAGR by roughly the same amount. It might not be the same depending on the accruing basis . But that’s a more advanced consideration that doesn’t matter that much to us.
A practical example
The chart and table above are meaningful, but difficult to relate to. To emphasize how much small changes in TER can cripple your long term returns, let’s look at a more practical example.
Say you invested USD 20k in the S&P 500 in 1988. And kept investing USD 2k every month until the end of 2019. Your total cumulative investment over the years is USD ~800k. What’s the value of your investments today for different TERs?
|TER (%)||Final investment value (USD)||Delta vs no TER (USD)||Delta vs no TER (%)|
The table is eye-opening. Just compare the final investment value for a TER of 0.1% vs 1%. In the long run you might be leaving more than a million dollars on the table! Even the impact of an increase in TER from 0.1% to 0.3% is huge after 30 years. You could buy a house with the difference.
The lesson learned is that you have to optimize for low TERs. The longer your investment horizon, the more important it is. What will you think next time your retail bank offers you a long-term investment in one of their funds for just 1% per year?
Impact of dividend taxes on ETF returns
Income tax on dividends also has a crippling effect on your long term investments. It works the same way as TER does. Both are recurring charges.
The math is however quite different. The TER is a small percentage applied to the total value of your investment. Taxes on dividends are a big percentage (in the order of 15-50%) applied to a relatively small periodic payout: the dividend yield.
How small are dividend payouts? Let’s look at the historical dividend yield of the S&P 500.
Some additional context on the chart:
- Since 2009, the dividend yield for the S&P has been hovering around 2%. This means that for every USD 1,000 invested in the index you get USD ~20 in (pre-tax) dividends per year
- Historically, dividend yields used to be higher. The S&P 500 expanded from 100 to 500 companies in 1957 . And from 1957 to 1990 only five years saw yields under 3%. A sharp structural change took place in the 1990s. The drop in interest rates and an increase in the number of tech companies – with typically pay out little dividends – drove yields down 
- The spike in 2008 is caused by the index plunging during the financial crisis. A price decrease makes the dividend yield look higher even if dividends stay constant
All in all, for our purposes ~2% is a good estimate of the S&P 500 dividend yield. For global funds, the figure is slightly higher (~2.5%).
TER-equivalent of dividend taxes
Alright, so dividend yields are ~2%. What taxes do you pay on these dividends?
We’ll dividends are income. And you pay taxes on income. So your dividends are taxed at your marginal income tax rate. This can be anywhere from 0% to 50%. And depends on the rest of your income. There’s little you can optimize here. It is what it is.
But there’s another type of taxes you pay on your dividend income: withholding taxes. As explained in this post, investing through an Irish domiciled implies paying withholding tax of 15% on your dividends. A better option is to invest in US domiciled funds. You can benefit from the Switzerland-US tax treaty, fill a DA-1 form, and effectively reduce withholding taxes to 0%.
How much can we optimize dividend taxes? The math becomes easy. The delta in dividend taxes form the best to not-so-good scenario is 15% (0% for US fund, 15% for Irish fund). 15% delta tax applied to the ~2% dividend yield of the S&P 500 results in an effective annual loss of 0.3% (or 30bps). The effect of not optimizing your dividend taxes through a US domiciled fund is equivalent to holding an ETF with a TER that is ~30bps higher.
Luckily we already know the impact of a TER that is 30bps higher. You just have to scroll up.
If you’re a passive investor, managing your portfolio should be little hassle. If you have a long investment horizon of, say 20-30 years, it’s worth to spend time upfront minimizing expenses. Especially recurring ones. The impact of recurring expenses such as TER and dividend taxes on long term returns is huge. It compounds over time. And can have a devastating effect over your long term returns. Holding recurring expenses in check can save you hundreds of thousands down the line.
Last updated on April 22, 2020