Management Fees Do Matter
A dear friend of mine works with a ﬁrm that charges him a management fee to invest his money in a basket of mutual funds. In his case, the funds are bond funds, so it would be unfair to compare the results to the S&P 500. His return last year was 6%, net of fees, which totaled 1.38%.
In eﬀect the funds yielded 7.38%, which is quite good for a basket of bond funds. The funds had experienced some appreciation due to the drop in interest rates, but my friend cannot count on that to happen regularly. If interest rates stay the same this year, his yield will be lower. Should they rise, the net value of his investment will decrease.
While 1.38% in fees doesn’t sound too high, think of it from another perspective. My friend paid 18.7% of his return (that being 1.38% divided by 7.38%) – in a good year – for management fees. That makes the fees sound a bit steeper.
Furthermore, while the manager’s portion of the fees is 0.65% per year, which doesn’t sound like much at ﬁrst, consider the following example. For the sake of simplicity, assume my friend has a $500,000 portfolio, which means that the 0.65% management fee adds up to $3,250 per year. That’s quite a bit of money, particularly when you think about how quickly it adds up over a ﬁve- or ten year period. If you’re still not convinced that fees matter, keep reading.
Would you like to be able to trade in your car and pay cash for a new one every ﬁve years? Maybe you’d prefer some other pricey toy, or a fancy vacation. It sure seems like investing directly could allow one to do just that; in the end, you’d have thousands of extra dollars at your disposal. While I understand paying for advice and education once, the fact that management fees are an annual expense is cause for concern.
Let me give you real number examples: the average US equity mutual fund’s annual expense fee is 1.43%. However, over the years investors have gotten smarter about fees. The average fee of mutual funds held by investors is 0.79% (of course, this does not include sneaky sales load fees that can be as high as 5.4%).
The fee range for the ETF options we recently reviewed in the May issue of Money Forever is 0.07% to 0.38%. If for example, you had $100,000 in a typical investor mutual fund charging 0.79% and you swapped it out for an ETF with a similar composition of stocks charging 0.07%, you’d save $720. That’s a 90% savings in fees for essentially the same performance.
For folks investing in mutual funds that deal with stocks, I suggest making the time to review your options. Unless you’ve found one of the few funds that consistently beats the S&P 500, are you really better off? After all, an educated investor can put together a safe, diversiﬁed, and proﬁtable portfolio without loading up on high-fee mutual funds or paying someone annually to do it for them.
While we all know the phrase “penny wise and pound foolish,” we don’t want to be penny foolish either. If your portfolio is leaking pennies, the leak can quickly add up to a big loss. After all, $720 here and $720 there starts to become real money pretty quickly.
If a certain mutual fund is exactly what you want and there doesn’t appear to be a cheaper alternative, then go for it. However, do not make your choice based on past performance alone. More often than not, you can find a suitable ETF alternative with very similar holdings for a fraction of the fees. Plus, ETFs are generally much more liquid than mutual funds.