The other day I was talking with a friend about saving and investing (my favorite conversation). This friend of mine, Jamie, was trying to wrap her arms around her companies 401K and its investment offerings. Jamie wants to start contributing to her 401K to save for retirement and get the company match, but remembered a conversation she overheard about how I hated mutual funds.
She wanted to know specifically why I was not very fond of them.
I went on to explain to Jamie that it’s not all mutual funds I despise, just those actively managed ones that are riddled with high fees and under performance. I told her the thing that peeved me most was the fact that the excessive fee they charge is supposed to be justified due to outperforming their benchmark, meaning you’re paying them to get you better than market returns vs. the benchmark. The problem is that something north of 85% of all fund managers actually under perform their benchmark (google it for the exact number).
So wait…why are you paying them the high fees again???
Let’s use a quick example and assume you invest in mutual fund that uses the S&P 500 as the benchmark and that has a 1.25% management fee associated with it. The fund returns 9% before fees and the S&P 500 returns 8.75%. At first glance you’re like “woo hoo.” However, after the fund takes their 1.25% cut, you are left with a 7.75% return.
You pay the 1.25% every year no matter what!
The fund is down for the year; you pay the fee.
The fund manager under performs the benchmark, you pay the fee.
Even if they match the performance of the benchmark, you pay the fee.
Even if they beat the benchmark by less than the 1.25% fee, you pay the entire fee.
This doesn’t make sense to me, especially when there is an alternative.
The alternative is to look for the mutual funds that are known as passive index funds, and come with a significantly lower fee. Vanguard has some of the most popular funds, VTSAX comes to mind with a 0.05% fee. This guarantees you the return of the benchmark less the incredibly small fee. If the benchmark returns 9%, you’re looking at 8.95% that you get to keep.
The reality is that fees matter, especially over decades of investing.
Why would you pay a premium when 8 or 9 times out of ten you pay for the pleasure of underperforming the market???
Fees; The Stealth Wealth Heist
If you’re investing in actively managed mutual funds you’re being robbed and you don’t even know it (now you do). It’s happened right under your nose. A gap of just 1% adds up to an insane amount of money. You will be amazed when I show you how much of your money is being skimmed from your brokerage account.
For illustration purposes let’s assume you have two options:
- Invest in a passive index mutual fund with a 0.05% annual fee ($0.50 per $1,000 invested)
- Invest in a actively managed mutual fund with a 1.05% annual fee ($10.5 per $1,000 invested)
In order to illustrate the havoc that fees can play on your wealth, I am going to use Personal Capitals free fee analyzer tool (try saying that 10 times fast). But before we go into comparing the two examples, let’s first define a few other assumptions:
- We will assume retirement at age 65
- We will assume you start contributing $18,000/year to your 401K every year until retirement
- We will assume an annual compound return of 8% (the one that floats around the internet)
- We will assume an annual $5,054/year annual match from your company
Option 1; The passive index route @ 0.05% annually
Over the course of 36 years of making contributions to your 401K, you contribute $829,951 (your contributions + employer matches). By the time you reach retirement age your portfolio has earned $3,100,884 due to compounding, leaving you with a total account value of 3,930,835.
However, you have $45,567 less than you could have had due to the 0.05% fee. Said another way your total earnings could have been $3,146,451 ($3,100,884 + $45,567). Therefore, fees ate up 1.45% of your earnings.
That is not bad at all. I can live with that!
Option 2; The actively managed route @ 1.05% annually
Over the course of 36 years of making contributions to your 401K, you contribute $829,951 (same amount as above). By the time you reach retirement age your portfolio has earned $2,338,495 due to compounding, leaving you with a total account value of $3,168,446.
However, you have $807,956 less than you could have had due to the 1.05% fee. Said another way your total earnings could have been $3,146,451 ($2,338,495+ $807,956). Therefore, fees ate up 25.7% of your earnings.
That is almost $1M in fees and you end up with less money. It would be one thing if you paid that much in fees and ended up with more money than in option 1 above. But the fact that you pay $807K in fees and end up with 26% less money if absolutely nuts!
Fees matter and actively managed funds suck (in my opinion of course)!!!
Feel free to try and find a diamond in the rough, but outside of a hand full of investors, you will be hard pressed to find a fund that legitimately outperforms their benchmark for any sustained period of time. Anyone can get lucky for a year or two, but I will let the probabilities guide my decision, and with 85%+ underperforming, I will choose the passive index fund every time.
Now that you know how important the consideration of fees is in your investment selections, maybe it’s time for you to finally pull the trigger and open up that FREE Personal Capital account, so you can perform this analysis on your current investments now.
Full disclosure: This site does get a small commission for your Personal Capital sign up, but I never recommend anything that I don’t actually use myself. Also, I only recommend things that I truly believe would be useful in helping you build your own wealth. Would greatly appreciate your support in signing up for an account if you don’t already have one.
– Gen Y Finance Guy
A friend of mine is an active mutual fund manager. He manages about $20B of a $120B EuroPac fund (one of the largest). You should see his $20M house!
Being a fund manager at a big fund is the best job ever.
Great post! I think more and more people are getting some understanding of how negatively those fees can affect their portfolios. Even though I’m well aware, it still astonishes me every time I see an example of just how bad those fees are.
Excellent advice. With all the advertising these days, you’d think that having an advisor who takes 1% of your AUM and using funds with high expense ratios would guarantee investing success, but all it does is guarantee high fees.
If you stick with index funds, it’s easy to DIY and you can save on both advisor and fund fees.
Thanks for the in-depth analysis in this piece. The average investor cannot be bothered to pay attention to fees, but as you pointed out, they can eat away a significant portion of one’s nest egg over time. In today’s advanced tech-world, there is little excuse for not using Personal Capital’s fee analyzer.
So true! I think it is horrible that so many companies force their employees into these bad mutual funds with no options for low fee index funds.
Invest in a passive index mutual fund with a 0.05% annual fee ($5 per $1,000 invested)
Invest in a actively managed mutual fund with a 1.05% annual fee ($105 per $1,000 invested)
I believe those are off by a decimal place. Should be 50 cents and $10.50 right?
Thanks Brian – correction made. I have not been good about reading through the post several times to correct the inaccuracies of my fast typing :)
This is a great point. Talk about looking at the long-term benefits for the ones managing the mutual funds! I will be biased towards Vanguard funds.
Finance Solver – I think a lot of us in the personal finance community are biased towards Vanguard. They are really the gold standard.
Great point! Where I’m from, in Canada, funds charge upward to 2.5% !!! It is absolutely impossible for me understand how those funds are able to get billions under management with those kind of fees.
XYZ – That is freaking nuts, I can’t imagine paying 2.5%. I would rather take my chances and pick stocks instead :)
If only I could convince my mother that there’s no benefit to actively managed funds. “But they know more than us!”
*bangs head repeatedly against desk*
Pia! Keep at it, there’s a really good video from John Oliver that gets the point across well if it helps, just google it. It took about 2 years but I wore my father down to the point where he realized that he should understand where and how his money is invested. He’s now an indexer :D haha
Man this is the article that has finally hit it home for me, I need to get on top of this :O..
It’s that thing where you attempt to justify paying the fees as you feel you’re getting higher returns..
Which is I suppose the trap that we fall into and aren’t holding funds accountable for this
Thanks for writing this and it’ll go on my to do list! :)
Hopefully you will start keeping more of you money with paying less in fees.