Everything from interest rates to corporate earnings can affect the value of your portfolio. But these data points have nothing to do with you.
However, over the course of your career as an investor, there is one thing you can control that has a direct impact on the returns you get from your investments: what you pay for them.
Mutual funds and exchange-traded funds each come with annual fees. But unlike champagne and sports cars, a price tag is not an indicator of a good product.
“It’s the only consumer product that has an inverse relationship between quality and cost,” says Christine Benz, director of personal finance and retirement planning at Morningstar.
That’s because any amount you pay in fees goes into the fund company’s pocket, not your investments. Over time, fees can have a significant impact on your responses.
“Choosing low fees is the best way to pick a good fund,” says Benz. “The single most reliable data point we have for performance is the fund’s expense ratio.”
Here’s how investing in low-fee funds can boost your returns.
Why some funds come with low fees
The annual fee you pay to own a mutual fund or ETF is known as the expense ratio, expressed as a percentage of the fund’s assets. If you invest $1,000 in a fund with a 1% expense ratio, you’ll pay $10 in fees a year, which covers the cost of running the fund.
Fees vary from fund to fund, but one of the biggest differences is how the fund is managed.
Actively managed mutual funds cater to investing investors who build portfolios with the aim of beating a certain market benchmark. The cost of trying to win a certain segment of the market is that the fund company has to pay someone (or several people) to manage the strategy – a cost they pass on to you.
Rather than trying to beat the market index, hedge funds seek to replicate its performance. Because diversifying your S&P 500 holdings is relatively straightforward, you don’t need a highly paid manager to run the fund. As a result, passive investments tend to be cheaper than active ones.
But wait, isn’t it better to squeeze in more money to beat the market instead of matching it? In theory, yes. But consistently outperforming the market is difficult.
Take the S&P 500, a common measure of the broader US stock market. Last year, 79% of active funds underperformed the index compared to the S&P index’s active scorecard. In fact, the average active fund has trailed the S&P for 12 consecutive calendar years.
How high fees hurt your returns
It’s important to note that some active funds have long-term track records of outperforming the index, while others are purpose-built for market niches where investors can benefit from the manager’s expertise.
“If I’m going to spend on an expense ratio, it’s going to be in the segment of the market where a manager’s expertise improves my chances,” says Doug Boneparth, a certified financial planner and founder of BoneFide Wealth in New York City.
The good news for investors is that fund expense ratios are coming down across the board. In the year In 2021, the average expense ratio for all mutual funds and ETFs was 0.40%, according to Morningstar — less than half of what investors paid on average in 2001. The average active fund charges 0.60%, while the average passive fund charges 0.12%.
Those numbers may seem insignificant, but remember: Every dollar you pay in fees can grow at a compounded rate of your other investments. So when you’re comparing two similar funds, it’s better to lean toward the cheaper one.
Say an investor invests $10,000 in a fund that charges a 0.60% expense ratio and holds it for 40 years, earning an annual rate of return of 7%. At the end of the period, the investment was worth about $118,000, and the investor paid about $11,000 in fees, according to Bankrate’s mutual fund fee calculator.
If you lower the expense ratio to 0.12%, the investment is worth about $143,000, with fees of about $2,500. Lower the ratio to 0.03% — a common fee among major companies’ broad-market ETFs — and 40 years of sales fees total $636. Investment cost: about $148,000.
“That’s right. [Vanguard founder] As Jack Bogle used to say, Benz says, “You get what you don’t pay for.”
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