This is the seventh installment in our series on how individual investors can assess their financial health.
In my experience, I’ve found that many people have no idea how much they’re paying for the privilege of investing. And survey data supports my observations. Ignorance is not bliss. Analysis of investment expenses suggests that many people are probably losing a substantial portion of their potential lifetime investment gains to these expenses—and a considerable portion of them are avoidable.
To understand the true scope of investment expenses, you first need to know the different forms they can take. You’re not alone if you didn’t know about some of these costs.
- Brokerage fees – Also known as trading commissions, these are what you pay when you buy or sell securities through a broker. Typically, brokerage costs accrue every time you make a trade, though there are a variety of fee structures.
- Mutual fund stated costs – These are the fees that mutual fund management collects for running the fund. They are expressed as a mutual fund’s expense ratio.
- Mutual fund trading costs – The costs that funds incur through trading their underlying securities are not included in the expense ratio. They are additional expenses that are passed along to fund investors.
- Retirement plan administrative costs – In retirement plans, the costs associated with managing the plan itself are over and above the brokerage fees and mutual fund expenses.
- Advisory fees – If you have a financial advisor, he or she may be paid on the basis of sales commissions, a percentage of your assets, or a flat fee.
- Cash drag – Mutual funds tend to keep a certain percentage of their assets in cash to support fund share redemptions. These assets are doing nothing, but are still part of the assets subject to the expense ratio of the fund. This is not an explicit fee but it reduces the return of your investment, so I have included it here.
- Taxes accrued by the mutual fund – Finally, it’s necessary to account for the tax burden that a fund creates for its investors through the fund’s trading.
The Impact of Fund Expenses
A 2011 Forbes article estimates that the average all-in cost of owning a mutual fund is 3.2% per year in a non-taxable account and 4.2% in a taxable account. This estimate is likely on the high end, but it’s certainly possible that it is accurate. A more recent article estimates that the average all-in cost of investing in an actively managed mutual fund is 2.2% per year, ignoring taxes. But rather than debate these numbers, the crucial question is how much you are spending in your own accounts.
While a 1% or 2% difference in expenses may seem small when compared to variability in fund total returns of 20% or more, the long term impact of those expenses is enormous. Let’s do a little math to show how pernicious expenses can be.
Imagine that you can earn an average of 7% per year in a 60% stock/40% bond portfolio. The long term average rate of inflation in the United States is 2.3%. That means your real return after inflation is 4.7% (7% – 2.3%). If your expenses in a taxable account are as high as the Forbes estimate, you’ll end up with only 0.5% per year in return net of inflation. This implies that the vast majority of returns from stocks and bonds could be lost to the various forms of expenses.
If you find that implausible, consider the fact that the average mutual fund investor has not even kept up with inflation over the past 20 years, a period in which inflation has averaged 2.5% per year, stocks have averaged gains of 8.2% per year. The extremely poor returns that individual investors have achieved over the past twenty years are not just a result of high expenses, but expenses certainly must play a role given the estimates of how much the average investor pays.
A useful rule of thumb is that every extra 1% you pay in expenses equates to 20% less wealth accumulation over a working lifetime. If you can reduce expenses by 2% per year, before considering taxes you are likely to have a 40% higher income in retirement (higher portfolio value equates directly to higher income) or to be able to leave a 40% larger bequest to your family or to your favorite charity.
How to Get a Handle on Expenses
To estimate how much you are paying in expenses, follow these steps.
- Obtain the expense ratio of every mutual fund and ETF that you invest in. Multiply the expense ratios by the dollar amount in each fund to calculate your total cost.
- Look up the turnover of each fund that you invest in. Multiply the turnover by 1.2% to estimate the incremental expenses of trading. A fund with 100% annual turnover is likely to cost an additional 1.2% of your assets beyond the started expense ratio.
- If you use an advisor, make sure you know the annual cost of the advisor’s services as well as any so-called wrap fees of programs that the advisor has you participating in.
- Ask your HR manager to provide the all-in cost of your 401k plan.
- Add up all of your brokerage expenses for the past twelve months.
Collecting all of this information will take some time, but given the substantial potential impact of expenses on performance, it’s worth the trouble. If, when you add up all of these costs, your total expenses are less than 1% of your assets, you are keeping costs low. If your total expenses are between 1% and 2%, you need to make sure that you are getting something for your money. You may have an advisor who is providing a lot of planning help beyond just designing your portfolio, for example. Or you may be investing with a manager who you believe is worth paying a premium for. If your all-in costs are greater than 3% per year, you are in danger of sacrificing the majority of the potential after- inflation gains from investing.
It is hard to get excited about tracking expenses or cutting costs. The evidence clearly shows, however, that reducing your investment costs could make the difference between a well-funded retirement or college savings account and one that’s insufficient.
Future returns are hard to predict, but the impact of expenses is precisely known. The more you pay, the better your investments need to perform just to keep up with what you could achieve with low cost index funds. This is not an indictment of money managers but rather a reminder that investors need to be critical consumers of investment products and services.
For more analysis of the devastating impact of expenses, MarketWatch has an interesting take.