When It Comes to Investing, You Get What You Don’t Pay For
I bet you’ve heard the phrase “You get what you pay for.” For many of the things we buy, a lower cost is typically associated with lower quality. So if we want the best of something, we believe we have to pay a premium. But when it comes to investing, this adage does not apply. Making a good investment does not have to cost you a premium. In fact, the less you pay in investment fees, the more you keep for yourself and the better your overall returns.
Do you know what you’re paying in investment costs? If you’re buying or selling investments through your broker, you already know about the trading cost or commission (the fee the broker charges you to buy or sell the investment). You see that fee stated separately on your trade confirmation or account statement. But did you know that investment funds like mutual funds and exchange traded funds (ETFs) charge you a fee as well? All funds charge fees. It’s how they make money for managing the investments for you.
Investment funds are a great way to build a diversified portfolio in a practical and low-cost way. Rather than buy individual stocks or bonds, you can buy shares of an investment fund that already owns hundreds and sometimes thousands of individual stocks or bonds. But, you need to be aware of the hidden costs before making an investment.
The Hidden Costs
Investment funds charge fees commonly known as an expense ratio – the annual cost of fees as a percentage of the fund value. These fees are simply deducted from the value of the shares, so when you buy and sell shares, the fees have already been deducted. You didn’t see that coming, did you?
So how much does this expense ratio cost you? According to a recent study by Vanguard and Lipper, the average expense ratio for all funds in 2014 was 1.02%. I know what you’re thinking, 1% is not a huge amount. Well, as you pay this fee over a long period of time, it adds up. Over a 30 year period, a $100,000 investment earning 6% per year with a 1.02% expense ratio will cost you $152,070. That’s more than your original investment! Hold that investment for 10 more years and you’re looking at total costs of almost $350,000.
A similar fund with a 0.18% expense ratio costs you $30,219 for that same $100,000 investment over 30 years, a savings of over $120,000. Over 40 years, the savings is $280,000. Now ask yourself what you could do with an extra $280,000. A high expense ratio could cost you an early retirement or the lifestyle you want in retirement.
But I’m Paying for Better Returns
You may say that you are getting a better return by paying those higher fees because over the last year the fund has outperformed the market. You get what you pay for, right? Wrong. Research shows that funds that perform well over a one or two year period are not likely to continue that performance in future years. And over longer periods of time, like 20 years, they seldom beat the market. So that expensive fund you’re in is costing you more money but not giving you the returns to make up for it.
More Costs
It’s unfortunate, but investing can be full of fees. Besides the expense ratio, there are other costs lurking for investors.
Sales Charges are commissions you pay when you buy shares of a fund typically costing you 3-6% of the amount you invest. Sometimes you pay this charge upfront in what’s known as a “front-end load”. Other times, you pay this charge when you sell the shares (a “back-end load” or “deferred sales charge”). And in other cases, the sales charge can be recurring every year. Your goal is to avoid these charges by choosing other investments.
Redemption Fees are charges you pay when selling shares of a fund. Typically they are used to discourage short-term trading, but can be imposed up to 5 years after you buy the fund. The maximum fee allowed is 2% of the value of shares being sold. Again, this is more money being taken from you and keeping you from your goal, so avoid funds that charge redemption fees.
Want to switch funds within the same fund family? You may be charged an Exchange Fee to exchange your shares from one fund to another.
Some funds charge an Account Maintenance Fee for maintaining your account. Typically you need to have a certain dollar amount invested to avoid this fee.
How to Avoid Hidden Costs
We think you should put more emphasis on the expense ratio and fees when choosing investment funds. ETFs are generally less expensive than mutual funds and don’t have the extra fees many mutual funds charge. An index fund that is managed to a market index is usually less expensive than an actively managed fund. You’ll get the average return for that market and pay much less in investment costs leaving more money for you when you need it. And because you’re investing over the long term, you’re likely to get a greater benefit from the ongoing lower costs than you are from one or two years of good returns in that expensive fund.
Your Action Item:
Check the expense ratios and other costs of your funds online at morningstar.com. Talk to your financial advisor about how to choose funds without the hidden costs and get what you don’t pay for.