Investing in mutual funds can be daunting for many new investors. There are literally thousands of mutual funds. When deciding among all of the choices, many new investors look straight to a fund’s past returns.

This is a mistake.

Past performance does not correlate with future returns. Every mutual fund advertisement says it in the fine print. Still doesn’t keep them from touting how they beat their benchmark index. When I evaluate mutual funds, I skip the table on past investment returns altogether. Instead, in my initial evaluation of mutual funds, I go straight to one number.

Fees, Fees, Fees

Mutual funds charge management and other fees when you invest with them. These are lumped into a catch-all term: expense ratio. You can usually find this number on the fund’s homepage or fact sheet. The expense ratio is the percentage of your investment that is taken away in fees each year.

Don’t look at performance, look at the expense ratio.

When you begin to look at a bunch of mutual funds, you quickly realize that there is a large difference in expense ratios between index funds and actively-managed mutual funds.

Index funds are passively managed, and therefore charge very low fees. They do not pay for expensive fund managers, and they pass those savings on to their investors. The most popular index funds charge less than 0.10% per year.

Actively-managed mutual funds, on the other hand, have a fund manager who creates a portfolio that aims to deliver benchmark-beating returns. A lot of money is invested in the fund manager and an army of research analysts. Many mutual fund managers will get to meet with executives at the companies they invest in. All of this research is not cheap. The average expense ratio for an actively managed mutual fund is 1%. There are many mutual funds that charge 2% or even 3%.

Do you get returns better than index funds with all this effort? Usually not. More than 80% of actively mutual funds failed to beat their benchmark index, according to a recent study by S&P.

The Impact Of Fees

What does 1% a year cost you? It may not seem like much. For every dollar invested, the actively-managed mutual fund takes just a penny to pay for its fund managers and research staff. But those pennies add up. Fast.

If I got a penny for every dollar invested in my actively-managed mutual fund…

Consider a 30-year-old physician who invests $50,000 a year and earns a 7% pre-expenses return until age 65. For a low-cost index fund with an expense ratio of 0.10%, the after-expenses return would be 6.9%, while for an actively-managed mutual fund with an expense ratio of 1.00%, the after-expenses return would be 6.00%. What’s the difference in the value of this investment at age 65?

You’ll end up with a lot more money if you keep your fees low.

By investing in low-cost managed funds, the physician’s annual $50,000 contribution would be worth $1.32 million more at age 65 because of the cumulative effect of the lower fees.

Fees Add Up Over TIme

The longer you have to invest, the more time fees have to erode your returns. As Warren Buffett wrote in his 2016 annual letter to shareholders,

As Gordon Gekko might have put it: “Fees never sleep.” – Warren Buffett

If you only invest for 5 years, 1% in fees only erodes your return by $8,000 compared to index funds. Mid-career physicians who have 20 years to invest will have their capital gains cut by $218,000. New attending physicians and residents with 35 years to invest will lose $1,320,000 in potential capital gains because of fees.

Years To Invest Cumulative Cost of Active Funds
5 $8,000
10 $36,000
15 $99,000
20 $218,000
25 $425,000
30 $769,000
35 $1,320,000

The younger you are, the more important it is to minimize fees because of your longer investing time horizon.

Conclusion

Investing in low-cost index funds is one of the easiest and most high-yield things you can do with your finances. If you need some ideas on how to get started, check out my guide on how to build an index portfolio using Vanguard funds.

What do you think? Do you invest in index funds? Did the effect of fees on investment returns surprise you?

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