Fees are one of the most important determinants of investment performance and something that every investor should focus upon. This article will show why fees are so important, list some of the typical fees investors can expect to pay, and focus on some investment types that generally carry high (and low) fees. (Discover how investment strategies and expense ratios impact your mutual fund's returns. Check out Stop Paying High Mutual Fund Fees.)
TUTORIAL: Choosing Quality Mutual Funds
Why Fees Matter
It is easy for investors to forget about fees when focusing upon other important subjects such as asset allocation or security selection. However, in addition to the overall market movements and an individual's stock picking abilities, the level of fees that investors pay is one of the most important determinants of investor performance.
The following example might astonish you. The numbers below assume that you contribute $3,000 to your retirement account in year one. Each year, as your salary increases, you increase your contribution by $250. So in year two, you contribute $3,250, in year three you contribute $3,500, and in year four you contribute $3,750. You then continue to gradually increase your contributions for the remainder of your career (30 years) and earn an 8% annualized return on your diversified portfolio. Although you earn 8% gross returns, your net return will be reduced by the amount of fees you pay. The higher the fees, the lower the return you actually "receive."
The only difference in the investment programs in the chart below is the level of fees - everything else is identical. Look at the difference in the amount that you end up with at retirement, depending upon how much you pay in fees each year. The numbers are nothing short of staggering.
Due To Fees
|Source: From Piggybank to Portfolio|
A common retirement goal is to be able to withdraw between 3-5% of an investment portfolio each year during retirement. In the scenario above, if two individuals had invested throughout their careers in a similar manner, but one person had paid 0.50% in fees and the other had paid 2.00%, the difference in their annual income during retirement would be more than $5,000 each year. That means that one person would have $420 less each month on which to live, just because they had paid excessive fees on their investment portfolio during their working years. (If you are investing small amounts regularly into an exchange-traded fund, be sure to do it right. See Dollar-Cost Averaging With ETFs.)
Hopefully, the above example has convinced you of the importance of fees. While it is not always necessary to aim for the lowest possible fees in a portfolio, it is generally a good idea to select investments and investment providers that fall in the range of those available. With that in mind, the matrix below demonstrates some typical fees. (Note: the fees in the matrix below are indicative and are intended to serve as a starting point for further research and analysis.)
|Online Brokers||Stock Trade ($)||Option Trade ($)|
|Brokerage 1||8.95||8.95 + 0.75 per contract|
|Brokerage 2||7.99-9.99||7.99-9.99 + 0.75 per contract|
|Brokerage 3||7.95||7.95 + 0.75 per contract|
|Brokerage 4||9.99||9.99 + 0.75 per contract|
|Brokerage 5||7.00||7.00 + 1.25 per contract|
|ETFs||Issuer X||Issuer Y|
|S&P 500 Index||0.06%||0.09%|
|Small Cap Index||0.17%||0.28%|
|US Bond Index||0.11%||0.24%|
|Emerging Market Stocks||0.22%||0.69%|
|S&P 500 Index Fund||0.17%|
|Large Cap US Stocks Average||1.13%|
|US Small Cap Index Fund||0.31%|
|Small Cap US Stocks Average||1.40%|
|US Bond Index Fund||0.22%|
|Intermediate-Term Bonds Average||0.94%|
|International Large Cap Stock Average||1.37%|
|Emerging Market Stocks Average||1.69%|
High and Low Fee Investment Types
There are certain types of investment products that inherently carry high fees (remember that fees come in many forms, including commissions and bid-ask spreads.) Generally speaking, the more esoteric an asset class, the higher the fees you will pay. For instance, "frontier" market mutual funds generally carry higher fees than U.S. Large Cap stock funds, commodity ETFs usually carry higher fees than an ETF that tracks the EAFE Index of large cap international stocks, and purchasing a corporate bond from Brazil will have higher fees than a U.S. Treasury Bond. Many derivative products can also carry high fees. While standardized option contracts and futures contracts can have fees that are reasonable and transparent, products such as equity-linked notes are notorious for their opacity and high fee structure.
Just as some asset classes gravitate towards high fees, some assets are geared towards low fees. Indexed products such as ETFs and index mutual funds usually offer relatively low fees and are therefore attractive to value conscious investors. When evaluating these products, it is important to keep in mind that there are often alternatives available from several providers (for instance multiple S&P 500 Index Funds.) Since the products are all essentially the same, the level of fees is likely to be the main source of diverging returns in the future; therefore, it really pays to select the lowest cost provider for indexed products. Remember, in general the more mainstream the asset class, the lower the fees, and vice versa.
Fee-conscious investors should pay careful attention to one particular type of mutual fund. Although mutual funds in general are not inherently expensive, some of them carry front-end load charges of as much as 5.5% of the investment amount. This initial hit to your principal makes it very difficult to outperform the market going forward. Many financial professionals (including the author) recommend never buying any mutual fund that carries significant sales charge since similar alternatives are often available without the charge. If you do decide to purchase funds with a front-end fee, make sure that you research the fund thoroughly and are sure that you are getting sufficient value (in the form of expected future performance) in return for paying the fee. (Find out how to get the bank to pay you for using their services, not the other way around. Check out Cut Your Bank Fees.)
The Bottom Line
Fees are one of the main determinants of investment returns and over time investors that minimize fees tend to maximize performance. However, it is important not to let fees dominate your investment decision making process. Investors should select the appropriate investment provider for them and determine their appropriate asset allocation to help meet their financial goals. Only then should the investor turn their attention towards minimizing fees within the construct of their investment program.