Investment fees are one of the most important determinants of investment performance and something every investor should focus on. This article will show why fees are so important, list some of the typical fees, and focus on some investment types that generally carry high (and low) fees.
Why Investment Fees Matter
It is easy to forget about fees when focusing on 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 paid is one of the most important determinants of performance.
The numbers below assume 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 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 you end up with at retirement, depending upon how much you pay in fees each year:
Due To Fees
A common retirement goal is to be able to withdraw between 3% and 5% of an investment portfolio each year during retirement. In the scenario above, if two individuals invested throughout their careers in a similar manner, but one person had paid 0.5% in fees and the other had paid 2%, the difference in their annual income during retirement would be more than $5,000 each year. That means one person would have $420 less each month, just because they had paid excessive fees on their investment portfolio during their working years. (For related reading, see: 5 Signs Fund Fees Are Hammering Your Investments.)
While it is not always necessary to aim for the lowest possible fees in a portfolio, it is generally a good idea to select investments and investment providers that fall within a certain range. With that in mind, the matrix below demonstrates some typical fees. (Note: the fees in the matrix below are indicative and are intended to serve as a starting point for further research and analysis.)
|Online Brokers||Stock Trade ($)||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%|
|U.S. Bond Index||0.11%||0.24%|
|Emerging Market Stocks||0.22%||0.69%|
|S&P 500 Index Fund||0.17%|
|Large Cap U.S. Stocks Average||1.13%|
|U.S. Small Cap Index Fund||0.31%|
|Small Cap U.S. Stocks Average||1.40%|
|U.S. 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 Fee Investment Types
There are certain types of investment products that inherently carry high fees. 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 tracking 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 derivatives can also carry high fees. While standardized option contracts and futures contracts can have reasonable and transparent fees, products such as equity-linked notes are notorious for their opacity and high fee structure.
Investment Types With Low Fees
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. There are often alternatives available from several providers to evaluate (e.g. 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 as a whole are not inherently expensive, some of them carry front-end load charges up to 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 recommend never buying any mutual fund carrying a significant sales charge since similar alternatives are often available without it. If you do decide to purchase funds with a front-end fee, make sure you research the fund thoroughly to determine you are getting sufficient value (in the form of expected future performance) in return for paying the fee. (For related reading, see: What's the difference between a load and no-load mutual fund?)
The Bottom Line
Fees are one of the main determinants of investment returns, and over time, minimizing fees tends 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 toward minimizing fees within the construct of their investment program.
(For further reading, see: Stop Paying High Mutual Fund Fees.)