Why Management Fees Really Matter

You hear it all the time on sites like this.

“Keep your fees low!”

“Use low cost mutual funds!”

“Active funds can’t beat the market – so don’t pay for them!”

And the reason almost doesn’t need stating: any fee taken from your earnings is money lost.

In 2014, Morningstar reported that the average mutual fund fee was 1.25%.

But thaIf you’re like me when I first started investing then you’ve probably thought, “Meh, it’s 1% a year, that’s nothing”.

Well, I hate to tell you (almost as much as I hated to tell myself), that’s the wrong way to think about it.

The thing is, it’s not only the fee that you’re loosing out on, it’s also the earnings from that fee. And sure, maybe you’re just starting out and think that it’s still “not that much”. [Insert handy-dandy graphics here]

 


These graphs make the following assumptions:

  • Initial Balance: $11,000
  • Annual Contribution: $5,500
  • Funds grow for 40 years
  • Average Market Return: 7%

Is it a coincidence that the annual contribution in this scenario is the same as the maximum yearly IRA contribution? Probably not.

Using these commonalities, three different fees are assessed:

  • The 2014 average: 1.25%
  • A rough ‘middle-ground’: 0.5%
  • Vanguard’s lowest fee: 0.04%

In the graphs above notice that the difference between the management cost of the maximum and minimum fee is $158,975. Holy crap! You could have bought a second house for that amount!

But that’s not the worst of it – look a little closer and something doesn’t add up. The management cost is $158,975 but the difference in the returns is $403,916.

WAIT A DOGGONE MINUTE

Where did the other $250,000 go?

Well, my friends – that’s the true problem with fees. Sure, maybe someone can be ok with paying $159,000 in fees over 40 years. But if that’s all you consider then you’re missing the big picture.

MAXIMUM FALLACY

It’s not as simple as saying, “Well, 1.25% is only $159,000 over 40 years. I’m happy to pay that because I don’t understand investing.”

Not only are is that neglecting the $250,000+ lost in potential returns, it also forgets the beauty of index funds – their low cost.

By now, I’m sure we are all aware of the “Balanced Portfolio” idea. It’s been beat to the ground, but for good reason.

Index funds are another topic, but in summary:


Index funds provide a simple way to ‘balance’ our portfolios. I say ‘balance’ in italics because it’s still possible to specialize an index but be diversified in that specialization – ie a real estate index would purchase a large variety of real estate investments. Thereby if one investment turns south, the index isn’t hit too hard. But if real estate as a whole falls, then that index is in trouble. See – ‘balanced’.


BACK TO THE TOPIC AT HAND

I can’t fault anyone for thinking like this. After all – I’ve done it myself. And I thought this way for a long time until I really dug into the numbers. For a final comparison, take a look at the chart below.

 

By investing in that average cost fund, the potential ending balance is cut by nearly 30% (compared to the low cost index fund). I don’t know about you, but this isn’t something I’m ok with.

What are your thoughts? Are you investing in one of those average cost funds? Is some manager sitting behind a desk, attempting to beat the market for you – and making you pay for it in more that one way?

 

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