You might know that the stock market can rob you of investment income but there’s a more sinister thief that will rob you of even more—and it operate largely without your knowledge. That thief is fees. If you’re investing your money in any mutual fund or etf, you will incur fees because all funds require some sort of management.
In good years, your portfolio will underperform the market but in bad years, it will perform even worse. This happens because of all of those fees. If you arm yourself with some basic knowledge of mutual fund and ETF fees, you’ll be in a better position to reduce them.
Fees come in a variety of forms and not all funds charge all fees. There are transaction fees (also called a load) that are charged by the person who sold you the fund. These fees can be charged when you buy the fund (front loaded), sell the fund (back loaded), or both when buying and selling.
Typical transaction fees can be around $50, so if you are transacting relatively small amounts, these fees can quickly eat into your returns. If you invested $10,000 and the fund generates a 5% rate of return, your $500 return can get chopped down to $400-450. That’s a hefty 10-20% of your return!
There is also an ongoing fee, charged periodically as long as you hold the fund. This fee is the cost to manage and market the fund. It is expressed as a percentage of the fund’s value, and is typically called the expense ratio. For actively managed funds, the expense ratio can be as high as 2% or more.
Another factor that can rob you of your returns, though it’s not technically a fee, is the portion of your fund’s assets that are kept in cash. Since cash returns practically nothing, any part of the mutual fund that is kept in cash leaves less money to be invested in equities. If your $10,000 mutual fund keeps $1,000 in cash and $9,000 in equities, a 5% rate of return is going to yield $450 instead of $500.
This is going to add up over time to less and less returns than you would have had if the entire fund were in equities. Cash isn’t necessarily a bad thing. Well diversified portfolios have cash on hand to take advantage of great market buying opportunities but it shouldn’t be a significant percentage of the fund.
So what is the average investor to do? Ask these questions first. What are the fees associated with the fund? Ask for a fee schedule up front, so that there are no surprises. Do you need a minimum balance? If so, what is the penalty for not meeting the minimum?
How do the total fees compare to other similar products? Can you buy the fund on your own and skip the transaction cost? How much return does the fund have to generate so that you break even in any given year? Much of this information you can find online at Morningstar.com or on the fund’s website.
In many cases, investing in a passively managed fund will meet your investing goals without generating as many fees. There are many types of passively managed funds out there. They are tied to major benchmarks like stock market, commodities, currency, and some rather exotic measures. They will generate a rate of return close to the benchmark, and index funds generally have much smaller expense ratios.
This means that your rate of return over time is going to be significantly higher than if you were to place your money in the more expensive actively managed funds.
We’re not here to say that all actively managed funds are bad and we won’t say that all passively managed funds are good. What’s important is that you understand how fees work so you can make informed choices.
We will say that research indicates that passively managed funds tend to outperform actively managed funds over a long period of time so don’t forget to give them a second look.