What are Foregone Earnings
Foregone earnings are the difference between earnings actually achieved and earnings that could have been achieved with the absence of specific fees, expenses or lost time. Foregone earnings represent the investment capital that the investor spent on investment fees. The assumption is that if the investor had been exposed to lower fees, he or she would have generated a better return. This term is often used when referring to sales charges, management fees or total expenses paid to mutual funds, exchange-traded funds (ETFs) or other pooled investment vehicles.
BREAKING DOWN Foregone Earnings
Foregone earnings, as they relate to investment performance, can cause a big drag on the long-term growth of assets. Something as seemingly innocent as a front-end load or a 1% management fee can cost thousands of dollars as the years pile up, thanks to the wonders of compound returns. To limit foregone earnings, it is important to look at the costs associated with each investment.
Sales charges can be a significant expense for investors. The Financial Industry Regulatory Authority (FINRA) provides the following schedule which exemplifies potential front-end load sales charges required and various breakpoints often associated with different levels of investment in mutual funds.
Investment and Sales Charge
Less than $25,000 5.00%
At least $25,000, but less than $50,000 4.25%
At least $50,000, but less than $100,000 3.75%
At least $100,000, but less than $250,000 3.25%
At least $250,000, but less than $500,000 2.75%
At least $500,000, but less than $1 million 2.00%
$1 million or more No sales charge
Sales charges can be on the front end, back end or deferred. Back end and deferred charges often decrease gradually over the duration of an investment helping to decrease fees for long-term investors. Sales charges are commissions charged by distributors that compensate the broker for sales. Fees for individuals are typically lower when trading with a discount broker and some platforms may not include sales charges at all. Sales charges can also often be bypassed by investing through the fund company directly.
Sales charges for transactions through intermediaries are determined by the mutual fund. Some mutual funds provide investors with a breakdown of returns with and without sales charges. ClearBridge is one example.
The ClearBridge Aggressive Growth Fund reports returns with and without sales charges. As of November 30, 2017, the Fund’s average one year return without sales charges was 12.62%. With sales charges the return was 6.14%. The difference represents foregone earnings from sales charges.
Fund Operating Costs
Investors will also experience foregone earnings from mutual fund operating fees. Mutual fund operating fees typically encompass management fees, distribution fees, transaction fees and administrative costs. A mutual fund may report a gross expense ratio and a net expense ratio that includes these fees. If a net expense ratio is quoted then the fund has waivers and reimbursement agreements in place. Over time the fund’s expense ratio typically increases to its gross expense ratio when the discounts expire.
Investors can consider management fees and gross versus net expense ratios when comparing funds for foregone earnings. Passively managed funds typically have lower expense ratios than actively managed funds. Actively managed funds require higher management fees and transactions costs.
For an example, say you have $10,000 to invest and one fund charges 0.5%, while the other fund charges 2%. Both funds offer exposure to a similar segment of the market. If you invest in the 2% fund, your investment return would decrease by $200 annually. Investing in the 0.5% fund only charges $50. If you choose to invest in the 2% fund, your foregone earnings from fund fees would be $150.
Redemption fees may also be charged by mutual funds to prevent investors from short-term trading. These fees are determined by the fund company. Their timeframes for payment can range from 30 to 365 days after the initial purchase. Redemption fees are paid back to the fund for trading and operational costs. Avoiding redemption fees can also be a factor helping to reduce potential for foregone earnings.