We are fortunate to have a brilliant CFA here at WrapManager, Doug Hutchinson. At our weekly staff meetings, he has been testing our abilities with financial quizzes. These are great tests of your investment knowledge. Good luck!
Scenario:
ETF A has an expense ratio of 0.05%
ETF B has an expense ratio of 0.20%
Assume ETF A and ETF B track the same index and both track that index perfectly. So if the index returns 5%, then ETF A will return 4.95% (including the expense ratio) and ETF B will return 4.80% (including the expense ratio).
Assume the index returns 5% a year for each of the next 3 years.
Manager A invests $10,000 in ETF A at the start of Year 1
Manager B invests $10,000 in ETF B at the start of Year 1
What is the difference in wealth accumulation (in dollar terms) between Manager A and Manager B after 1 year? After 3 years?
Choices:
A) $15 after Year 1, $45 after Year 3
B) $5 after Year 1, $45 after Year 3
C) $15 after Year 1, $49.49 after Year 3
D) $15 after Year 1, $48.45 after Year 3
Answer:
The correct answer is C) $15 after Year 1, $49.49 after Year 3
ETF A will have a return of 4.95% for each of the next 3 years (5.00% - 0.05% = 4.95%)
ETF B will have a return of 4.80% for each of the next 3 years (5.00% - 0.20% = 4.80%)
Manager A: Starts with $10,000 at the start of Year 1
Year 1 return: $10,000 x 1.0495 = $10,495
Manager B: Starts with $10,000 at the start of Year 1
Year 1 return: $10,000 x 1.048 = $10,480
Difference in wealth accumulation after Year 1 = $10,495 - $10,480 = $15
Manager A: Starts with $10,495 at the start of Year 2
Year 2 return: $10,495 x 1.0495 = $11,014.50
Manager B: Starts with $10,480 at the start of Year 2
Year 2 return: $10,480 x 1.048 = $10,983.04
Difference in wealth accumulation after Year 2 = $11,014.50 - $10,983.04 = $31.46
Manager A: Starts with $11,014.50 at the start of Year 3
Year 3 return: $11,014.50 x 1.0495 = $11,559.72
Manager B: Starts with $10,983.04 at the start of Year 3
Year 3 return: $10,983.04 x 1.048 = $11,510.23
Difference in wealth accumulation after Year 3 = $11,559.72 - $11,510.23 = $49.49
The difference in wealth accumulation will compound over time. For Year 1, the difference in wealth accumulation was $15, but the difference in wealth accumulation between Year 1 and Year 2 was greater than $15. ($31.46 - $15 = $16.40). Likewise, the difference in wealth accumulation between Year 2 and Year 3 was greater than $16.40 ($49.49 - $31.46 = $18.03).
Our Investment Policy Committee considers scenarios like this and others as we formulate recommendations. If your scenario is similar to the one above and you have questions, please call us at (800) 541-7774. We are happy to help you analyze your unique investment scenarios.
This posting is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.