How High Fees Can Kill a Good Investment Strategy

We can’t control the markets; we can control the costs that help or hinder our investment strategy. What may seem like only a slightly higher fee today can add up to a significant cut of your net return over time. And the first step in minimizing fees is spotting them.

All mutual funds and exchange-traded funds – you buy funds directly from fund companies and ETFs on stock exchanges – carry a management fee. That fee is percentage-based and referred to as the expense ratio, a measure of what it costs an investment company to operate your fund. Your funds’ management presents this in annual terms, though it deducts the fee from the fund’s assets each business day – lowering your return.

To quote John Bogle, founder and former chief executive of fund giant Vanguard Investments, you must ensure that “the miracle of compounding returns [doesn’t become] overwhelmed by the tyranny of compounding costs.” Fees also vary widely across different types of funds:

  • Actively managed funds charge higher fees than passively managed funds, not surprisingly. You may be surprised how much higher the fees are. For the range of funds below, actively managed funds on average charged fees five times higher than the average index mutual fund and four times higher than the average ETF. Index funds passively track indexes like the Standard & Poor’s 500; ETFs tend to be index products.
  • In general, large-capitalization stock funds carry lower fees than smaller-cap funds and developed market funds have lower fees than emerging market funds.

From this chart you may think small expense ratios carry little consequence. Wrong: Just as the compounding effect of time multiplies asset growth, compounding also multiplies the detrimental effect of expenses.

The chart below illustrates what the fee gap does over time to a portfolio. This example compares the net return of an actively managed fund with an average expense ratio of 0.8% against an index fund with an average expense ratio of 0.11%. Both invest in U.S. large-cap stocks and assume an initial investment of $100,000 and an average return of 6%.

Over 30 years, the difference in the expense ratios results in a net return of nearly $100,000 more for the investor who chose index funds versus actively managed funds. Here is the long-term impact of investment costs on portfolio balances, assuming an initial investment of $100,000 and an annual return of 6%:

 

Alternative investments – such as private equity or hedge funds – carry fee structures more complex and even more expensive than traditional mutual funds and ETFs. Often alternative investment options charge not only a 2% annual management fee (higher than the typical actively managed fund), but also take a 20% share of the fund’s profits.

These costs create significant hurdles for the investment that looks to generate a competitive net return. Recently, a number of institutions and endowments realized this when many of their allocations to alternative strategies underperformed against the broad market. In fact, the California Public Employees’ Retirement System (CalPERS), the nation’s largest public pension fund, recently announced plans to eliminate its entire hedge fund program, valued at roughly $4 billion, largely due to unjustifiably high costs.

Our firm, to cite one example, attempts to take advantage of any opportunity to cut expenses as long as such a move doesn’t hurt the expected long-term performance of the portfolio. Happily, industry trends generally pushed expense ratios lower over time and we were able to further reduce costs.

Even from a starting point much lower than the average actively managed portfolio, we further reduce the weighted average expense ratio of our recommended portfolios. For example, at our firm, the underlying expense of a typical portfolio with 70% stocks and 30% bonds dropped from 0.32% in 2009 to 0.23% today. From Dec. 31, 2000, through June 30, our 70/30 portfolio outperformed 89% of the funds in Morningstar’s Moderate Allocation category.

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Written by Ted Parchman, CFA, an investment associate at Truepoint Wealth Counsel in Cincinnati.

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