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Portfolio Leaks

by Tim Isbell (February 2014)

Last spring I discovered a big pool of water under our house. I narrowed it down to the feed line to a landscape irrigation system by noticing that the small red triangle icon on our water meter moved just a tiny bit in 30 seconds. For a better idea of how much water was leaking, I switched to a non-leaky line that carried water to the hose at the front of the house. Then I very carefully adjusted the faucet until the little triangle turned at about the same rate. The water dribbled through the hose and onto the concrete, where it very slowly wet an expanding circle. I couldn't believe that was enough water to explain the pond under the house. The professional plumber who was looking on confirmed that this was not the source of water for the pond.

Still, I wanted an accurate measure of how much water was leaking. So I read the meter accurately, and then we all left the house for 2 hours. When we returned, I read the meter and did some math. The tiny leak computed to 25 gallons every 24 hours! That's 175 gallons every week leaking under our house - with no way to escape. The professional plumber was wrong to say the leak was too small to matter.

Investment portfolios leak just like this, and many financial professionals assess the problem as inaccurately as my (also expensive) plumbing professional. A little 1% leak in our portfolio here and a half-percent leak there doesn't seem like much. But over time, these end up costing us a lot of money.

For example, if our $100,000 portfolio's underlying asset allocation of stocks and bonds grows 8% per year for ten years we should have a $215,892 portfolio. But if our portfolio leaks 3.5% per year we only have $155,297. That's a $60,000 leak! If this goes on for 20 years, the loss computes to $225,000. In retirement, these leaks cost us several years of living money! Very few of us can afford to let this happen! 

This web page identifies the leaks and helps you reduce them. 


Expense ratio

The expense ratio represents all the operating costs of the fund. It includes the research to determine which stocks and how many shares to hold in the portfolio. For actively managed funds, this is usually the largest part of the expense ratio. It also includes various clerical, accounting, 12b-1 marketing costs, and legal fees. 

The expense ratio is a percentage of the share price. So if the share price is $30 and the expense ratio is 0.05% that means 15 cents/share of your money goes to this purpose. 

Expense ratios range from 0.05% for large-cap index funds to 1.5% for very actively managed specialty funds. In my case I invest in very low-fee, often index funds, so my overall portfolio's expense ratio is about 0.11%. 

But the expense ratio does not include "trading costs"! 

Trading Expenses

Trading Expenses include brokerage fees, "market impact costs" (that a mutual fund company causes on prices because of the size of their transactions), and the spread cost. These are extremely hard to quantify and are unreported anywhere; instead, they are buried in the share price. Trading costs are much higher for an actively managed mutual fund (due to frequent buying and selling) than for an index fund (due to much lower portfolio turnover). For more on this see The Real Costs of Owning a Mutual Fund, which reports that the average stock mutual fund incurs about 1.44% transaction costs. 

Loads & Redemption Fees

Some funds charge as much as a 5% up-front fee at the time an investor purchases the fund though the average among front-load funds is closer to 1%. Other funds charge a fee at redemption though sometimes an investor can hold the fund long enough to waive the fee. My portfolio has no funds with loads or redemption fees.

Management fees

Sometimes an investor hires a professional to buy and sell mutual fund shares (or individual stock shares) on their behalf. The managed account fee is in addition to all the other fees. Managed accounts usually require a minimum investment of $100,000 to $500,000, and charge a fee of 1-2%. I used these sorts of accounts in one season of life but eventually realized that the manager is unable to provide returns high enough to cover their expenses. I have not used managed accounts for several years.


I'm not a tax professional; instead, I pay a good one. Even so, it's important for investors to understand a few things about income taxes in the U.S.:

  • Tax on earned income (such as income we receive for working a job) is progressive, meaning that we pay very low taxes for the first few thousand dollars we earn. As our income increases, the tax rate on each additional dollar increases. 
  • We pay tax on interest and most mutual fund dividends at the same progressive rates as apply to earned income. We pay taxes in the year we receive distributions, whether or not we reinvest them. The investment company reports these to us (and to the IRS) in our annual 1099 forms.
  • Capital gains on shares of stocks and bonds held over one year are also taxed progressively, but at a substantially lower level (called the long-term capital gains rate) than earned income. Capital gains tax is not due until it is "realized", which is when we sell the shares. 
  • Earned income that we put in traditional retirement funds (such as traditional IRAs, 401Ks or 403Bs) initially escapes taxes, until we begin taking money out of the account. When we hit retirement age and start withdrawing it, every dollar is subject to tax at the earned income rate. In the year we turn 70.5 years old, we must begin taking a Required Minimum Distribution (RMD) from these retirement accounts. The IRS provides a schedule for the amount each year.
  • Earned income that we put into a ROTH IRA gets taxed in the year we put it in but never again. And there is no RMD.

This is by no means the complete story on taxes, but it helps us see that taxation is a significant item in investment decisions. Tax efficient strategies vary widely with individual circumstances, so I'll leave it to you to find a good tax person and do some reading from sources like Kiplinger's Personal Finance and CNN Money magazine, both listed in Resources/Links. Also, see my web page on Mutual Fund Distributions & Taxation for some strategy tips.


When the economy is running right, the Federal Reserve (the U.S. Central Bank) manages the economy to try to keep inflation at 2.5-3.5%. At least, that seems like the "sweet spot" for a healthy economy. Fortunately, the Fed seems pretty adept at managing it these days. So when I need an estimate of future inflation number I usually use 3%.

However, over the past eight years, inflation was more like 2.1%. Even though this is lower than the historical average, it is still a significant erosion of purchasing power when compared with the other Leaks. Most reports of market returns ignore inflation, though when you see the term Real Return, it indicates that this is the return with inflation factored into it. Here's the website I use to find historical values for inflation: U.S. Department of Labor Consumer Price Index


In addition to this list of leaks, here's one often ignored item that squirts a little money back into portfolios! It's far more important than most people realize.

When the news reports that the S&P 500 was up 11% last year, this usually means the share price of the S&P increased by 11% and ignores the dividends paid to investors during the year. In fact, the set of stocks in the S&P 500 index pays a pretty steady monthly dividend that adds up to around 2% each year! The term Total Return indicates that it includes reinvested dividends and capital gains.

Netting it all out

Now that we have the leaks identified let's build a chart to compare the leakage from a Professionally Managed Portfolio to the leakage from a Self Managed portfolio. The numbers (below) are typical and represent the percent of our total invested money in each year. The goal, of course, is to maximize the returns on the bottom line.

The Professionally Managed Portfolio is what investment houses want to sell investors. It's full of all the fees and expenses that go with actively managed accounts. Remember, these are just typical numbers - your's could be higher!

The Self Managed Portfolio is the kind that the Investments section of this website is all about. It's where a personal investor strips out most of the fees by managing his/her portfolio, filling it mostly with low-cost index funds according to an asset allocation tuned to their risk tolerance, and re-balanced it at least once a year. It's not "rocket science." If you can understand this web page and the rest of the Investments section of this website, then you can do it.

In the chart below, the Total line ignores inflation because it's the same for both portfolios and there's nothing an individual investor can do about it. It also ignores the Tax line because this is so dependent on individual circumstances. However, the Self Managed Portfolio's much larger share of index funds generates less taxable income. So, adding a number for Taxes would make the Self Managed Portfolio look even better. In Vanguard's analysis, an index fund results in about a 0.45% advantage over an actively traded fund.

 Leak    Professionally Managed   Portfolio   Self Managed Portfolio
 Expense Ratio 0.8 0.2
 Trading Expenses 1.4 0.5
 Loads/Redemption Fees 1.0 0
 Managed Account Fees 1.0 0
 Taxes 0.7 0.3
 Inflation 3.0 3.0
 Total (ignoring inflation) 4.9 1.0

Stop and think about this a minute. To just break even the professional manager must deliver a 3.9% higher return than the do-it-yourself investor. Historical data indicates that this is very hard in any single year and virtually impossible year-after-year. Fortunately, we can build a much better portfolio on our own! To see how to do this, please take a look at the Investments intro page, and then browse around in the Investment section links you find there.

All the best,


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