When you invest in a mutual fund or an exchange traded fund, you likely expect to pay some sort of fee. But what are your investments actually costing you? If you’re not sure, you’re not alone. It’s not like you’re handed a menu of charges to choose from when it’s time to place your order. Even when you know where to look for investment costs, the information can be difficult to digest.
Let’s fill in some of the blanks by covering one of the main sources of investment costs: fund management fees.
Fair Fund Management Fees
One reason advisors recommend investing in a mix of index or index-like funds is their ability to efficiently capture global market returns without your having to personally juggle thousands of individual securities at a time. What a hassle that would be.
That’s why you may choose to hire a fund manager and let them do the heavy lifting for you. In exchange, fund managers deserve reasonable compensation for services rendered.
What’s “reasonable”? To discover how much fund management is costing you, start by looking for each fund’s expense ratio. You can find this information in the fund’s prospectus, or by searching online for its name or ticker symbol. Many broad market index mutual funds or ETFs have annual expense ratios of 0.03% (3 basis points) or less.
Some fund managers pile on extra fees, or loads, beyond the ones reflected in their expense ratios. These should also be disclosed in the fund’s prospectus, and can include:
- A one-time front-end load when you buy shares of the fund
- A one-time back-end load when you sell shares of the fund
- Similar contingent deferred sales charges (CDSCs) and other redemption fees
Hiding and Seeking Fund Fees
Because fund management fees are typically bundled into each fund’s share price, you’ll barely notice they’re there. But they still cost you real money.
For example, in a recent working paper, “Obfuscation in Mutual Funds,” academics from the University of Washington, MIT, and The Wharton School at the University of Pennsylvania compared the 2019 costs and performances of two S&P 500 Index mutual funds. Before fees, their gross returns were nearly identical at 31.46% vs. 31.47%. But one fund manager charged a lean 0.02% (2 basis points). The other one charged up to an all-in 5.08% (508 basis points). Once you know that, it’s easy to tell which fund will leave more money in your pocket after fees.
Are you having trouble finding a fund manager’s fees? Consider this central finding from the same paper:
“Using bespoke measures of complexity designed for mutual funds, we find evidence consistent with funds attempting to obfuscate high fees.”
In other words, the study found that lower-cost funds usually provided short, easy to understand fee disclosures; the higher-cost funds often buried their costs in lengthy and complex legalese.
Why complicate things? When searching for a particular type of investment, there are almost always funds available that do not charge loads and similar add-ons, and do clearly disclose their costs. That’s why we prefer simple and thrifty over complex and expensive fund management.
Low costs are important. But they’re not the only reason to favor one fund over another. Some funds cost more to manage because it’s more expensive to participate in their target market.
For example, an emerging markets fund will usually have higher expense ratios than a general U.S. market fund. So, first, identify available funds that fit your unique investment goals. Compare their expense ratios, apples to apples. Weed out any funds that charge loads, or bury their fee disclosures in long-winded blather. Then select suitable funds with the lowest costs.
As fiduciaries and Certified Financial Planner™ practitioners, one of the critical functions we perform on behalf of our clients is this exact analysis. While cost isn’t the only criteria we consider when building diversified investment portfolios, it’s certainly one of them, as it has a direct impact on the long-term performance of any portfolio.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.