Your mutual fund fees are too high

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I was recently approached by a family member to review their 401k to help them understand what they were invested in. This account is “managed” by one of the common investment advisers (Edward Jones, Charles Schwab, ect.) so I would have expected to be able to take a quick peek and see some kind of investment strategy. Not only was I wrong but I discovered many of the funds in the account were charging fees well above index fund fees and not providing excess return. You might be in the same situation and if that is the case, your mutual fund fees are too high!

Understanding Mutual Fund Fees

We will begin by reviewing what mutual fund fees are and why funds charge fees.

Fees are measured by the expense ratio which represents the total cost to run the fund’s operations as a percentage of the total assets under management. If the fund has $100 million invested and the expenses for the year are $1 million then the expense ratio is 1%.

The fees are used to cover operations which includes paying the investment managers, accounting and legal services, and other day-to-day costs of operating the fund.

There is also a separate fee known as a 12-b 1 fee that covers marketing or advertising of the fund. This fee can be as high as 1%.

The problem  is you never see a transaction in your account statement for the fees you are being charged. The fees come out of the assets of the fund and you never know it. In other words, if you invest $10,000 in a fund that charges a 1% expense ratio and the return for the year is 0%, you will actually finish the year with $9,900 in your account. The fees are simply deducted from the assets of the fund and lower the return that is reported.

The expense ratio is something that must be reviewed before you invest in a mutual fund.

Why some funds have higher fees

One of the current hot topics in the investment world is the discussion of active versus passive management. This is one of the major factors that you will consider when choosing between mutual funds.

Active management is when an investment professional picks and chooses investments based on an investment strategy in order to “beat the market”. Actively managed funds charge higher fees and the expense ratio will be higher.

Passive management is  also known as indexing. If you want to invest in the stock market but do not want to pay the higher fees charged by an actively managed fund, then you would choose a passive investment strategy. An S&P 500 index fund would track the performance of all of the stocks that make up the S&P 500. Passively managed funds charge lower fees and the expense ratio will be lower.

Actively managed funds cost more due to a variety of reasons. Investment managers that are able to beat the market should be paid more based on their performance. These types of funds might also engage in hedging strategies or incur more trading costs. The problem is actively managed funds don’t always lead to excess returns.

If you haven’t recently reviewed your account statement to monitor your actively managed fund performance, you might be in the same boat as my family member. Their account had around 20 funds with many of them invested in some of the same stocks. These funds were actively managed but most of them did not beat the performance of index funds but charged much higher fees! This made me question the investment adviser who was overseeing the account.

How high should the expense ratio be?

To understand if your mutual fund fees are too high, it is best to start with the funds with the lowest costs as a reference point. Vanguard created the first S&P 500 index mutual fund back in 1975 and they still have some of the lowest cost index funds today. I am comparing Vanguard funds for simplicity but other companies offer funds with similar structures.

Passive (Index) Fund Fees

Vanguard’s 500 Index Fund Admiral Shares (VFIAX) has an expense ratio of .05% which is about as low as an expense ratio can be. In order to invest in the Admiral Class index funds they do require a minimum investment of $10,000.

If you can not invest $10,000, there is a lower class fund called Investor Shares. This fund requires a minimum of $2,000 or $3,000 depending on which type of account you are investing the funds in. An education saving account requires a minimum of $2,000 while a regular brokerage account or IRA requires a minimum of $3,000. The Investor class fund has a higher expense ratio of .16% so this is something to keep in mind. If you are able to meet the minimum of $10,000 then the Admiral class fund will save .11% on expenses. Either way, these funds are a very cheap way to gain exposure to the S&P 500 stocks.

Vanguard’s Total Bond Market Index Fund Investor Shares (VBMFX) is an index fund representing the total bond market and includes exposure to corporate bonds, US treasury bonds, and mortgages. This bond fund also comes in Admiral and Investor share classes and has the same expense ratio and minimum requirements as the S&P 500 index funds. The Admiral class requires $10,000 minimum and has an expense ratio of .06% while the Investor class requires $2,000-$3,000 minimum and has an expense ratio of .16%. It would not be possible to develop a bond portfolio this cheaply on your own.

Active Fund Fees

Vanguard Explorer Fund Admiral Shares (VEXRX) is an actively managed fund that seeks to identify small-cap growth stocks. The Admiral class expense ratio is .35% while the Investor class is .49%. This fund has an expense ratio .29% higher than the S&P 500 Index fund. .29% is not a large number so what is the big deal?

If you eventually have $1 million or more in investments than these costs will add up over time. .29% on $1 million is $2,900. Over 10 years this is a cost difference of $29,000 – an amount that could buy a new car.

Passive vs. Active

In order to determine if paying for an active fund is worthwhile you must compare the active returns versus the passive return.

This chart shows the performance of the Explorer Fund which is the actively managed fund with a .35% expense ratio.  For the 1 year return measure the fund has outperformed the Russell 2500 growth index but on the 3+ year periods the fund has under performed the index. This indicates that paying for the active management of this fund is not worth it.

 Vanguard Explorer Fund Admiral Shares

Vanguard Explorer Fund Admiral Shares Returns (Source: Vanguard)

By comparison, the Vanguard Small Cap Index Admiral Shares Fund (VSMAX) has performed better than the actively managed Explorer fund and has lower fees of .08%. This fund also includes over 1,400 stocks while the Explorer fund only includes 713 so there is more diversification with VSMAX.

 Vanguard Small-Cap Index Fund Admiral Shares

Vanguard Small-Cap Index Fund Admiral Shares (VSMAX) Returns (Source: Vanguard)

Conclusion

The goal of the article was to make you aware of the fees that are being charged to the funds in your 401k or IRA. Over a long investment horizon, even a small fee difference of .30% will add up as your portfolio grows. If your account is with an investment adviser, you have to take an active role in reviewing your account because your adviser simply does not care as much as you do. In fact, the adviser may be compensated for putting your money into funds that charge higher fees. While most investment advisers want the best for their clients, they are also working to make money.

It drives me kinda crazy to think about the number of folks out there who have tucked away their money in their 401k and expect to get to retirement without ever looking at their account. It just takes a little bit of time to become educated on the basics of investing. Don’t work so hard to earn and save money only to give it away to a mutual fund that is charging fees that are too high!

 

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