Investment Expenses: You Don’t Always Get What You Pay For

investment expensesTo economists, especially finance folks, prices are near magical things. There’s a near infinite amount of information packed into that number. Prices make the economy work.

And they work in the real world, too. Absent other information, prices are usually a decent proxy for value.

It’s pretty safe to assume that a $100 steak will be better than a $5 steak. You may not personally agree that it’s $95 better, but someone must think so, otherwise they wouldn’t sell them for that much.

It may be a better cut of meat, or maybe the animal only ate organic grass and was never kept in a pen, or it could just be branding, but something has led the seller to price it that high and some buyers to pay that much for that particular steak.

That’s not the case with investing. The prices of the underlying securities matter (a whole lot), but paying more to invest doesn’t get you anything extra.

When you look at mutual funds, price signals don’t tell you anything about quality – or at least not any quality you should care about. Usually a higher price just means you’re paying someone to get you higher returns.

You’re buying the skill of some active manager who you believe will take your money and make it sing. The only problem: that “skill” doesn’t actually exist.

What you’re really paying for is a bunch of really smart (and well-compensated) people making guesses. They’re not actually doing anything to increase your returns – they’re just adding noise. Sometimes you’ll get lucky and the noise will sound good for a while, but no matter what their marketing material says, it’s through no “skill” on their part – it’s random.

Your expenses are one of the few things you can actually control with your investments. The market is going to do what it’s going to do. And every dollar you spend on investment expenses is another dollar (with all of the future compounding that goes with it) that isn’t going toward your retirement. There’s no way to avoid paying investment expenses (even with the most basic index funds there’s a lot of work being done to make things go smoothly), but you don’t want to pay any more than you need to. So let’s actually put some numbers to this.

There are really two big classes of direct investment expenses (we’ll leave tax costs out of this analysis):

  • Commissions and Loads
  • Expense Ratios

Commissions and Loads

Commissions and loads are pretty much (though not exactly) the same thing. But they have the same effect on your investments. Commissions are something that someone gets for selling you something – it’s part of their compensation.

Loads are something that an investment company charges, and often (though not always) go to the person who sold you the investment. There are two basic types: front- and back-end loads. Front-end loads are charged to put your money to work – think of them as setup fees. Back-end loads (or deferred sales charges) are charges to get your money back that generally go to the person who sold you the fund – in other words, ransom notes.

A fee by any other name still costs you money, which means one thing: you have less money actually working for you than you sent over.

Let’s say you’re looking at a mutual fund with a 5% front-end load (this is fairly typical if you’re not putting in a ton of money). Now only 95% of the money you wanted to invest is being used the way you intended.

Imagine you invested $5,000 in a fund that charges a 5% front-end load, and you’re getting an even 6% return every year. Minus the 5% ($250), your initial investment comes to $4,750.

That might not sound all that bad, but it will compound over time. If you held that fund for the next fifteen years (and who wouldn’t with 6% annual returns?), you would end up $600 (well, $599.14) shy of where you would have been without such a fee. In other words, that 5% front-end load turned into 12% fee over time.

Quite simply, loads are bad. Even if you really want to invest in an actively managed fund, there are plenty out there with no front- or back-end loads.

Expense Ratios

You can avoid loads, but you can’t avoid expense ratios.

It costs money to run a mutual fund or ETF. There’s a lot going on to make sure that everything is running smoothly, everyone’s money is cleanly tracked and accounted for, and you as the investor never have to worry about the details.

But costs vary. You want to pay as little as is reasonably possible so you can use more of your own money to fund your retirement.

Let’s put some numbers around these as well. Using the same investment assumptions as before (an investment of $5,000 with a fifteen-year investment horizon and a level 6% return), what does a typical active manager’s expense ratio of 1% annually mean for your portfolio?

Over the fifteen-year period, you would have paid about $1,139 in direct fees, not to mention another $538 in foregone growth from those expenses compared to a (nonexistent) investment with no expenses.

When we compare this to a hypothetical index fund’s expenses of 0.2% per year, there’s still a pretty massive gap. The expenses on the hypothetical index fund (both direct costs and foregone growth) only came to $354.

So investing with that hypothetical active fund (which doesn’t have any better chance of getting you higher returns), just means you’ll end up about $1,300 shorter than the hypothetical index fund.

Actually, I’m understating the differences a bit. I ran these numbers on an annual basis, but in reality, expense ratios are handled on a daily basis (otherwise most mutual funds would mysteriously end up with a lot less under management on the days they charged their fees). So the impact of compounding isn’t as great here as it is in real life.

 

So much of investing is completely out of your control, so you need to use whatever tools you have available to you. Like I said, your investment expenses are pretty much the only part of investing you can actually control since you know what the rates will be beforehand.

So remember, “you get what you pay for” may apply when you’re buying a steak, but not when you’re investing, so why pay more?

For more on making the most of your investments, read our ebook A Minimalist's Guide to Understanding Financial Markets

 

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