Investing for retirement is no game. Every dollar counts, because over time, every dollar you save—or fail to save—creates a ripple effect that can significantly impact your quality of life in retirement. And reducing costs may be one of the easiest ways to improve the performance of your retirement portfolio. One of the industry’s greatest advocates of cost reduction, Jack Bogle, famously asserted that mutual funds with higher fees frequently underperform the market, and that assertion has stood the test of time. It’s unfortunate, then, that so few investors fully understand the fees they pay, particularly where mutual funds are involved.
The Mutual Fund Expense Ratio
The primary step in assessing how much your mutual fund costs is to look at the expense ratio. This is generally an easy number to locate online, and it reflects what investors are charged for the operation of the fund. The expense ratio includes management fees paid to the team overseeing the fund as well as administrative expenses. It may also include 12b-1 fees to cover marketing and distribution costs.
Expense ratios are expressed as a percentage of assets, and they typically range from 0.5% to 1.5% per year, although that amount could be considerably higher or lower depending on the traits of the fund. Index mutual funds are often far cheaper to operate because they don’t have an active management component.
Be aware, though, that the cost of owning a mutual fund goes beyond its expense ratio. Because funds are not required to report their trading costs to investors, there are well documented “invisible” costs as well. The Financial Analysts Journal recently published a study indicating that investors are paying, on average, an additional 1.44% in trading costs. Remember, that’s over and above the expense ratio, so many fund investors end up paying combined costs that are closer to 2% – 3%. And if you think superior fund performance usually justifies these high costs, you may want to look at the research. A U.S. News & World Report article points out that funds with the highest trading costs tend to underperform those with the lowest trading costs.
How Much of a Difference Is 1%?
It may appear that there is little difference between a 0.5% and 1.5% expense ratio, especially if your fund is enjoying a 10% or 12% annual gain, but that difference compounds—meaning it grows over time and takes more out of your earnings.
For instance, if you put $10,000 into two separate funds with similar objectives, with one expense ratio of 0.5% and the other at 1.5%, the first fund will cost you $50 per year and the second will cost you $150 per year. While the $100 difference may not be much in year one, the compounding effect becomes increasingly costly. If your fund gains 10% per year, that $10,000 would be worth $61,159 in 20 years in the 0.5% expense fund, but only $52,736 in the 1.5% expense fund. That’s a difference of $8,423 or $421 per year—all because of the compounded loss of that 1% in added expense each year.
Why Have Mutual Fund Fees At All?
Fees are necessary for mutual funds to operate. Pooling together capital from many different investors and then investing that capital in diversified portfolios of stocks and/or bonds requires administration. And that administration costs money. Fund management teams, researchers, and analysts all need to be paid too, so actively managed funds tend to be more costly than index funds.
Some investors prefer active management of their investments and the knowledge that someone is overseeing their funds. But if investors are aware of the costs and fees involved with various investment vehicles, they can determine whether those expenses are worth their potential value. Understanding the long-term effect of those costs can lead to better decisions about what securities to include or exclude from an investment portfolio.