How Do Fees Impact Mutual Fund Performance?
When shopping for mutual funds you may have noticed(or not noticed) the many different fees listed on the funds you are interested in. These fees can seem fairly small at first glance and may leave you asking how fees impact long term performance of the mutual fund.
It turns out that fees are extremely impactful on your long term returns. Annual operating fees for some mutual funds can exceed 1.5% of your investment while the benchmark for the fund itself might only return 8%.
What Types of Fees Do Mutual Funds Charge
There are quite a few different fees that mutual funds might charge. The ones we are concentrating on here are the ones that are percentage based which do the most damage to your returns over time.
An in depth guide to understanding mutual fund fees can be found here from the Securities and Exchange Commission.
Sales Load Fees
Sales load fees are for sales commissions and are paid when buying or selling a fund. A fee paid when you buy is called a front-end load and a fee paid when you sell is called a back-end load.
No-load funds don’t charge a sales fee at all, and are increasingly common these days. Be careful with these funds though, as they might make up the cost somewhere else.
A 1% front end sales fee means that if you invest $1000 you will only get $990 worth of the fund. Ultimately your investment returns will be reduced by the same 1% when you take the money out. If the mutual fund grows 10x in value to $10,000 you would have $9,900.
Sales load fees are worth paying attention to, however not as much as the recurring fees on the funds. The recurring fees compound and can really drag down your net worth over time.
Operating Expense Fees (Expense Ratio)
Annual operating expenses are the ongoing costs to operate the fund. A big part of this expense is the money paid to the fund managers and advisors. Marketing and selling of the fund is also covered here.
Typical annual operating expenses can range from 0.1% up to 1.5%. This is assessed yearly on your fund’s value. This means the fee compounds and can really add up over time.
Why do some funds charge much higher fees?
All funds will have some cost to operate, so all funds will have some fees. They must charge these fees back to their investors in order to turn a profit.
Index funds are generally very cheap to operate and these savings are passed on to the fund holders through much lower operating expenses. Some Vanguard funds charge as little as 0.04%.
Actively managed funds are those which have a manager who attempts to beat some part of the market. These types of funds commonly charge 1.5% or more. If an index fund for the S&P500 averages 9% over the long term, then the actively managed fund needs to average 10.5% return just to break even with an index!
That extra 1.5% may not seem like a lot, but that is actually a 17% (9%/1.5%) improvement over average to just break even! Now couple that with the fact that actively managed funds overall have a pretty poor track record of matching the market, much less beating it, and you see how significant the fees can really be.
Example of What 1.5% Expense Ratio Really Costs
Let’s quickly look at a concrete example. Let’s assume that you have $5,000 to invest annually and want to do so for 30 years. During this time assume the S&P500 will average a 9% annual return.
Let’s compare a no-load low cost S&P500 index fund with an expense ratio of 0.1% vs an actively managed fund with an expense ratio of 1.5% and a 1% front end sales load.
Returns Summary Table
|10 Years||20 Years||30 Years|
|Low Cost Index||$75,603||$252,848||$668.951|
|Difference in Dollars||-$5,575||-$38,590||$157,124|
|Difference in Percent||-7%||-15%||-23%|
As you can see over time the difference in these two approaches becomes evident. The active fund will have to beat the market handily just to give you a good chance of breaking even with an indexed fund. It’s not to say that this cannot happen, but the odds are against it.
If you want to play around with your own numbers you can download this simple spreadsheet calculator to do so.
Don’t Let Fees Put a Drag on Your Returns
Looking at the above table and graph it is easy to see just how much that 1% sales load fee and 1.5% expense ratio really costs you over time. There are plenty of no-load funds available now that allow you to avoid the sales charge.
As far as the operating expense charge, you can see that the costs over time can dramatically impact your returns. You will have to decide if the fund you want to invest in justifies the heavy cost. The good news is that you can always move your money into a better investment choice if you determine it isn’t.
Pay attention to these details because the long term affects of compounding can have a major impact on your eventual net worth. Nobody wants to work and save for decades to only acquire 77% of what they could have by picking a better fund option.