There is over $16 trillion invested in mutual funds. Mutual funds are an excellent way to invest and grow your wealth, however there is a great disparity in their fees. Studies show these fees are the greatest indicator of mutual fund performance. You may be even more surprised to learn that most financial advisors, professionals, and investors do not completely understand the total costs of the mutual funds they recommend and/or own.
In this article I will explain the different types of expenses so you are able to discover the true costs of your funds. They say you get what you pay for, but many times you don’t. Even when you do, you may not understand how much and exactly what you paid for. In the case of mutual funds, you may have to pay a lot more than you realize—and keep paying for as long as you own them.
- Expense Ratio – This expense is usually the only expense most believe they have to pay when owning a fund. It is used to pay for management fees, marketing and distribution costs. The average US Stock mutual fund expense ratio is 0.90%. You can find this cost in the fund prospectus or online.
- Transaction Costs – This cost can be difficult to determine since it is based on the number of trades the fund manager makes, the cost of each trade, the spread cost (difference between best quoted ask and bid price) and market impact cost (artificial stock price movements from large volume buys and sells). U.S. Stock mutual funds average 1.44% in transaction costs per year.
- Tax Costs – When you own a mutual fund outside of a qualified retirement account (IRA, 401(k), 403(b), etc), you pay taxes every year on your gains. If you buy a fund with investments that have appreciated before you bought it, you may have to pay taxes on these embedded gains, even if you didn’t receive any of the profits. In addition, if the fund manager actively trades in the fund, you will have to pay taxes, even if you don’t sell the fund. The average tax cost for stock funds is 1% to 1.2% per year.
- Cash Drag Costs – A portion of your investment in a fund is kept in cash so the fund manager can maintain liquidity for any potential transactions or redemptions by other mutual fund owners. Since not all of your money is invested, the performance of the fund will be affected if the investments increase in value greater than the cash held. In addition, you are paying the fund’s expense ratio on 100% of the money even though not all assets are invested. The average cost for cash drag is 0.83% per year.
- Soft Dollar Costs – This cost occurs when fund managers direct the money being managed to brokerage companies providing them with services like research for a premium rate, even if there are more efficient costs elsewhere. This is essentially a quid pro quo arrangement. Soft dollar costs total $1 billion annually, or up to 40% of all equity trading costs.
|Type of Fees||Average Fee for Taxable Account||Average Fee for Non-Taxable (Qualified) Account|
- Total Costs – When we add up all of the costs (excluding soft costs), the total cost for a Taxable Account, the total costs are 4.17%, and for Non-Taxable (Qualified) Accounts the total cost is 3.17%! This doesn’t include any broker commissions or advisor fees. If a mutual fund manager wants to average 8% a year, then he will have to achieve close to 12% consistently to achieve that! This is one of the main reasons the vast majority of active managers underperform their benchmarks.
Why should you care?
As I mentioned earlier, over the long-haul these fees are what determines the performance of your investment portfolio. Paying 2% more in fees or commissions will result in a difference of $385,441.91 (assuming a $10,000 per year investment with 8% annual return) over 30 years! From the graph below, you can see the impact different amount of fees have on an investment portfolio. Cutting 1% in fees can give 10 extra years of retirement income!
The example below shows a true life example of a mutual fund that returned 7.11%, but with the 1.23% expense ratio and 1.23% in trading costs, the net return was only 4.65%. The numbers below show how a gain of $3,555 turned into a gain of $2,325! This adds up every year, especially for taxable accounts.
So how can you take advantage of investing with a globally diversified portfolio with the best possible expected returns to grow your wealth without these extra fees? In recent years, the use of exchange-traded funds (ETFs) have exploded. Twenty years ago there only a small number that were rarely used. Now there are close to 1500 ETFs with $2 trillion in assets.
An exchange-traded fund (ETF) is an investment fund that is traded on stock exchanges throughout the trading day, much like stocks and unlike mutual funds. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500. Here are some of the reasons why I like ETFs and may be a good replacement for more expensive mutual funds.
- Low cost – When you add up all of the true costs of investing in a mutual fund, it can be over 3% in annual costs per year, taking over a third to half of your investment gains every year! Index ETFs aim to match the returns of their market index, often at a fraction of the cost than most mutual funds. There are some exceptions, but you can find hundreds of ETFs as low as 0.05%, with many averaging around 0.15% every year. Over time, you may do better than if you were invested in a similar mutual fund. In fact many ETFs outperform active mutual funds.
- Diversification – Diversification is a powerful tool to reduce certain types of risk in your portfolio. You can further diversify by industry, size of companies, by country, by sector, and other factors. This helps spread the risk among a wide variety of investments. Much of the market volatility of the last few years has been driven by economic events, natural disasters, and government activities that are outside any investor’s control. While we can’t diversify away all forms of risk, a flexible strategy can help you find and take advantage of investment opportunities in many market conditions. You can quickly achieve broad diversification and access to entire markets with ETFs. A single ETF can give you exposure to thousands of stocks, allowing you to invest in broad categories while taking on minimal single-stock risk.
- Simplicity – As an individual investor you could not replicate owning the entire stock market. Buying and selling stocks to keep up with the market is very cumbersome and would result in very high transaction costs. ETFs simplify this by wrapping this all up under one ticker. In addition, since our emotions can get the better of us when it comes to investing, ETFs depersonalize your investments. Since you basically own everything, you are much less caught up in which company or stock is best for the current market conditions. You want to make investing easy and not a part-time job that causes stress. ETFs give you that simplicity.
- Tax advantages – One of the problems with mutual funds is that you may have to pay taxes on gains even if you didn’t sell the fund or even received any of the embedded gains. ETFs buy and sell to track the underlying market index but the law allows them to do this without triggering investment taxes for the holder of the ETF.