If you want to retire, you need to invest. And if you want to invest safely, you need to diversify. For diversification, many turn to mutual funds as a low-cost and easy way to ensure that a retirement fund is sufficiently diversified to weather whatever financial storms may come. However, they’re probably doing it wrong.
When it comes to retirement, fund fees are an essential concern when choosing where and how to invest. While fees are always an expense, the magnitude of this expense grows over time, making fund fees a crucial issue for any retirement portfolio. This is because the impact that fees have on your returns will grow over time. This means lower fees are an easy way to improve the performance of your portfolio. But just how big is the fee impact? Huge, especially when it comes to mutual funds. Let’s take a look at this in more detail to get a clearer sense of just how much money those mutual funds might be costing you.
The Expense Ratio
When it comes to assessing how much mutual funds cost, you need to look at the expense ratio. This is a simple number to calculate, being the cost that the mutual fund company charges to pay for that mutual fund. Funds will usually express their expense ratio as a percentage, and the they usually vary from between 0.5% and 2%, depending on the fund and its operator. Some funds will have much higher expenses, which is why you need to be careful and pay attention to this number when shopping for mutual funds.
One of the interesting features of the expense ratio is that it incentivizes companies to get more assets under management—in other words, it motivates them to attract more money from more investors. The best way to do this is to outperform the market, but of course that’s hard. As a result, many mutual fund companies choose instead to advertise aggressively, which costs money and which is paid for by your expense ratios. Management bonuses, office space, research, and other costs all come out of your expense ratio, which is why there’s a limit to how low they can go.
How Much of a Difference is 1%?
Expenses can dramatically impact returns, even if the difference seems small. You might think there’s little difference between a 0.5% and 1.5% expense ratio, but that difference grows over time. For instance, imagine you can put $10,000 into two different funds, with expense ratios of 0.5% and 1.5%. The first fund will cost you $50 in annual fees, and the second will cost you $150 in annual fees.
That $100 difference doesn’t seem like much, but it compounds, meaning its severity will worsen over time. If your fund gained 10% per year, that $10,000 would be worth $61,159 in 20 years in the 0.5% expense fund and $52,736 in the 1.5% expense fund. That’s a difference of $8,423, or $421 per year. All because of compounding.
What makes matters worse is, just as management gets more fees the more you invest, the more you pay as well. The cost of this investment in terms of fees and lowered returns will only get larger the more you invest, making high fees a losing game. Investopedia has a nice chart on the topic, and you can calculate how much your fees are costing you with Vanguard’s customizable calculator.
Why Fees at All?
As mentioned above, fees are necessary in mutual fund companies because of the way they operate. A mutual fund pools together a lot of capital from different investors into one big pile, and then invests that in a diversified portfolio of stocks and/or bonds, in most cases. That administration costs money.
But, of course, there are more costs involved than just that. To ensure the fund outperforms, many mutual funds are actively managed. This means analysts and portfolio managers spend long hours doing research on different companies before deciding which stocks and bonds to buy. That expertise must be remunerated, and that comes from fees. Additionally, those people need infrastructure—reports, secretaries, computers, offices, and so on. Again, this is all quite expensive and comes out of expense fees.
One popular way around this is to invest only in passively managed funds, which have much lower expense ratios. The problem there is that many investors will invest in just one passive fund tracking one index, or they will mix different funds that give the illusion of diversification, without any real protection. While this strategy works in clear bull markets, at the moment of a downturn the investors will find themselves surprised to learn that their safe, low-cost approach may have cost them money.