Americans are starting to wise up, thanks to warnings from financial gurus and even the federal government. These warnings often sound like this: The fees that you pay to invest your money could take a huge bite out of your returns over the long term, so watch them closely. The average American investor has a 401(k) or similar retirement fund full of mutual funds. What does an investor need to know about mutual fund fees?
The actual term for fees is expense ratio—the amount of money a company pays to operate an investment. The calculation is simple: the operating expenses divided by the value of its assets under management. Expense ratio is reported as a percentage.
Different investment types will have varying expense ratios. Index funds will often be below 0.2 percent, while mutual funds that invest in international companies may charge more than one percent.
Wide Variation in Fees
When you make a large purchase you should always shop around, and that’s true in investing as well. Mutual funds of the same type may have widely varying fees. For example, the State Farm S&P 500 Index B fund (SNPBX) has an expense ratio of 1.36 percent, while the Vanguard 500 Index Fund Investor Shares (VFINX) comes in at 0.14 percent. Both funds do basically the same thing, but the difference in fees is gigantic. In fact, a variance of that size could mean hundreds of thousands in lost gains over 30 years.
Cost vs. Value
Nothing in finance is simple, and this case is no different. Yes, you should compare fees, but that’s not the whole picture. You also have to look at performance. What if the reason a fund has a higher expense ratio is because it makes you a lot more money, even after subtracting the fee, than the lower-cost fund? Who wouldn’t pay a higher fee to make more money?
Bad news—research shows that, in nearly all cases, higher fees don’t mean better performance. In fact, lower-cost funds often outperform their higher-cost counterparts.
These statistics have created a mass exodus in the mutual fund industry. In 2015 and 2016 investors pulled $627 billion out of actively managed funds and put $429 billion into lower-fee index funds. However, some experts advise not totally giving up on actively managed funds.
It might be true that most low-cost mutual funds will represent better value. Still, many actively managed funds that charge a premium do outperform lower cost funds. The problem is that most investors don’t know how to find them, don’t have enough money to invest in them, or invest through company-sponsored retirement plans that don’t offer them.
Financial education has focused hard on fees of late, causing many investment companies to lower fees on their funds just to stay competitive. The average actively managed fund fee is down to 0.75 percent, compared to one percent in the early 2000s. That may not seem like a large move, but it represents a lot of money back into your pocket.
What Should You Do?
First, seek out the advice of financial professionals if you aren’t well-versed in the investment industry. There’s more to picking funds than cost alone. The type of fund, its performance, your age and other personal financial metrics factor into building the best investment portfolio.
Second, look hard at the popular target-date funds, which automatically adjust your portfolio as you move closer to retirement. They genuinely are convenient, but they often come with high fees. If you aren’t getting the advice of a professional, these might make sense. However, individual funds might be a more cost-effective way to invest.
Finally, remember that the best way to set yourself up for retirement is to adequately fund your portfolio. Most people are behind on retirement. Ask a financial advisor for help with determining how much you should contribute monthly or use one of the many online calculators to get a general idea.