Investors are familiar with a common disclosure alerting them that “investing involves risk of loss”. But there is another important piece of information many investors overlook: what expenses come with this investment?
For mutual fund and exchange traded fund investors, this is called the expense ratio, and it is always disclosed by the fund company. 401(k)s and other employer-sponsored retirement accounts often have additional expenses. In addition, and if you purchased an annuity, there are other layers of fees and expenses you should know about. This article focuses on mutual funds and exchange traded funds (ETFs).
Most investors can agree that added costs to investing aren’t ideal. Cost can be in the form of trade costs, advisor compensation, and fund expense ratios. While trade costs and advisor costs are generally easier to understand and ‘see,’ fund costs aren’t always as clear to the average investor.
Why funds have an expense ratio
When you own a mutual fund or ETF, you are paying a fund company to manage a portfolio called the fund. There’s a cost to that: An expense ratio generally covers the fund’s portfolio management costs, administration, marketing, distribution and other expenses. These costs are allocated across all of the fund’s shareholders: a ratio of total cost divided by the fund’s total assets. The expense ratio is expressed as a percentage reflecting how much an investor pays the fund company. This cost is deducted from the fund’s total return, and the investor receives a net return. In a simplified example, if a fund’s gross return in a year was 10%, and the fund had a 0.5% expense ratio, the net annual return to investors would be 9.5%.
Expense ratios vary widely
Funds that are more expensive to administer generally have higher expense ratios. It’s important to note that expense ratios do not have a direct correlation to what a “good fund” may be considered. There are a number of factors to consider when selecting between funds, being cognizant of the expense ratio is important.
When comparing funds in the same asset class with the same gross return, the funds with lower expense ratios will generally result in higher net returns to the investor.
There are many funds which are quite similar – or even attempt to replicate the same index – yet carry far different expense ratios.
In the past decade, consumers have been placing pressure on fund companies to lower their fees. Yet still, plenty of funds still carry higher expense ratios than may be necessary. All things equal, lower cost funds will be able to pass on more return to the investor.
Knowing the expense ratio is important. Consider the cost of a gallon of gas at two stations next to each other. If one station charged 20% less per gallon, cars would be lining up because there’s no sense overpaying.
Not all funds are invested the same way. Actively managed funds generally carry higher costs than index funds. Active managers generally attempt to select specific stocks or bonds and to buy and sell them at specific times based on their research and outlook on the future. This adds costs which are passed to the consumer: salaries, trading costs and marketing expense. Index funds, on the other hand, are generally attempting to deliver the return of the part of the market they track, and generally have lower operating costs to pass on. And, different parts of the global stock and bond market carry widely different operating costs. Funds investing in emerging markets generally have a higher expense ratio than funds investing in U.S. markets.
While some differences in cost are justified, some are not and come down to a fund manager packing on more profit at the expense of the investor. While this can be great for the fund company, it is not great for the investor. An expense ratio above 1% is a clear indicator to understand what the investor gets for that cost. Even costs over 0.25% should be questioned.
But…that’s not all: advisor compensation
Yes, your financial advisor can probably choose to invest your money in funds with low expense ratios. Why wouldn’t they? There are some very valid reasons, but it’s good to ask. Often, revenue sharing arrangements allow advisors and their firm to receive a portion of the fund’s expense ratio. This could be a conflict of interest. Working with a Fee-Only advisor is one way to eliminate this. Fee-Only advisors only charge a fee for their services, and do not receive compensation from fund companies or others as an incentive to make investment recommendations.
Another form of compensation is trading commissions. These could result in giving your advisor financial incentives to trade your portfolio more than would otherwise be necessary. Trading can also result in realizing capital gains, which are taxable, a cost that reduces your long term total returns.
Advisory fees + fund fees: know what services you’re receiving.
Advisor compensation, like expense ratios, has gone down over time. Today, and advisor charging more than a 1% fee on assets under management may be charging above average for their services. It’s important to know what services you are getting for what you pay. Some advisors only manage your assets. Others also offer a range of financial planning services such as helping with tax planning, making sure your estate plan makes sense for you, and that you are properly insured and saving appropriately for your retirement.
Costs compound over time
Identifying expense ratios is the beginning of understanding the effect these expenses can have on compound investment returns over time.
While a 1% fee may seem low to some people, it adds up over decades – compounds, actually. When fees are higher than average, the total long term investment return may be suboptimal. This chart from the Securities and Exchange Commission illustrates the effect of fees on a portfolio with a 4% annualized return over two decades.
While the drag on performance is small over short periods, due to compounding, these differences becomes more pronounced over time.
Funds with higher expense ratios would have to consistently outperform their benchmark by an amount equal to or greater than their expense ratio to avoid a drag on performance. For example, if a fund that tracks the S&P500 index has an expense ratio of 0.50%, the fund would need to outperform the S&P500 by an absolute 0.50% to have the same net return. If the S&P500 returned 10% over a 12-month period, then the fund would have to have a gross performance of 10.50% in order to have a net return of 10%. It’s tough to expect a fund manager to outperform their benchmark every year only to provide benchmark returns net of their fees.
Fees matter. And there’s always a fee.
Mutual funds and ETFs have to disclose their expense ratios. Fee-Only advisors disclose their fees. Sometimes we say that our fees are low, but we show them. A worrisome statement by an advisor is “you don’t pay me anything”. Of course you do. When you don’t pay your advisor directly, they or their firm are being paid out of the fees charged by your investments.
Knowing what you pay when it comes to your financial life is important so you can be sure you’re getting the most out of your assets and that you are working with someone who places your best interests before their own. Understanding fees is the first step to better equip investors to make informed choices.
We recommend you speak with your financial advisor to ensure your investment portfolio is in alignment with your long-term goals. If you don’t have a financial advisor and would like to meet with a member of EVOadvisers, please follow this link to schedule time with an advisor.
Jack O’Brien CIMA® is a Certified Investment Management Analyst educated at Chicago Booth School of Busisness and Virginia Tech. EVOadvisers is a fee-only financial advisor based in the Scott’s Addition area of Richmond, Virginia. EVOadvisers also has an office in Irvington, Virginia to better serve clients in the Northern Neck of Virginia. If you have any questions about financial planning and would like to talk with one of our Certified Financial Planner professionals, check us out at www.evoadvisers.com or call (804)794-1981.
Sources
https://www.sec.gov/investor/alerts/ib_fees_expenses.pdf
https://www.nasdaq.com/articles/visualizing-how-investment-fees-impact-your-portfolio