From bull market to bull market over the past 10 years, investors’ long-term performance has been boosted by solid stock market returns. Over time, the stock market has consistently rewarded investors with the discipline and patience to stick with their investment strategy. However, many investors’ long-term investment performance may be losing ground due to investment fees and costs.
Fees And Expenses Costing Investors More Than They Think
Investment fees have come under intense scrutiny, and for good reason. Some actively managed mutual funds layer on various fees and costs that can amount to as much as 4% of an investor’s account balance, which is deducted from the account.
A financial advisor or wealth manager usually charges around 1% of an investor’s assets under management, which seems straightforward enough. However, depending on the type of investments, many advisors pass other costs onto their clients. These could include investment platform fees, annual fund management fees, and other expenses for administration, trading, custody and legal fees. Pretty quickly, a 1% advisory fee can increase to 2% or 3% in total fees.
With hidden costs such as revenue-sharing, trading costs and trailing commissions, mutual fund investors could be paying as much as 5%-6% from their account. Some fund managers turn their portfolios over more than 100% each year, creating even more trading costs and taxes that are passed on to clients.
The problem is many investors are not aware of the fees being charged. Either they weren’t fully disclosed, or investors never read or fully understood the disclosure. According to the FINRA Investor Education Foundation, 63% of investors either don’t think they pay fees or don’t know how much they’re paying.
The Impact Of Fees On Investment Performance
The problem with bull markets is they often mask the costs of investing. If investors understood the impact of fees and expenses on their long-term investment performance, they might be more careful with selecting investment options. An investor’s mutual fund or financial advisor might be generating positive returns. However, they still may be costing the investor hundreds of thousands of dollars that could otherwise be accumulating in their account.
Consider this hypothetical example. You invest $200,000 over 30 years with an assumed 6.5% annualized return. After 30 years, your investment would have grown to the following based on how much you paid in fees:
• 3% fee: $560,134
• 2% fee: $740,906
• 1% fee: $981,678
When considered in this light, you could say that any fund or advisor that charges two to three times more in total fees than another investment option is inhibiting your ability to grow your capital.
Are Higher Investment Fees Ever Justified?
If you just consider mutual funds, the amount of fees and expenses charged by a fund is based largely on the fund manager’s investment style or objective. For example, funds that are actively managed with the fund manager buying and selling securities in an attempt to outperform the market charge higher fees than funds that are passively managed.
That may be fine if the fund manager consistently outperforms the market. However, many don’t. According to Morningstar, 76% of active fund managers failed to beat their market benchmarks over the 10-year period ending June 2020. Of the small percentage of fund managers who have outperformed the market, fewer than 15% have been able to repeat their performance consistently.
It’s not that most fund managers are poor investors. Many are exceptionally good. The challenge for fund managers is that because of the fees investors pay, they have to outperform the market by as much as 3% to overcome the average 2% in fund costs, which are reflected in the fund’s net returns. When you consider all investment costs, some fund managers’ real hurdle may be closer to 5%. This is the primary reason passive index funds, many of which charge between 0.2% and 0.5% in annual fees, have generally outperformed active funds in recent years.
Balancing Investment Performance Potential And Investment Costs
To keep investment costs to a minimum, you could simply invest in low-cost, passively managed index funds or exchange-traded funds (ETFs). But these are not foolproof, as there are now thousands to choose from and some that are very risky. If you prefer to invest with the guidance of an advisor, there are other options for balancing performance potential and investment costs.
Over the past several years, robo-advisors have become a popular option among younger investors. Robo-advisors, such as Betterment and Wealthfront, charge as low as 0.25% annually on top of investment costs. They help you set up an asset allocation strategy using low-cost ETFs. For larger portfolios or added fees, you can have limited access to an advisor.
For investors with more than $250,000 to invest, and who want a customized stock portfolio, another option is to work with a Registered Investment Advisor (RIA). RIAs are fiduciary investment advisors that charge around 1% to manage investor portfolios. If there are any additional fees and expenses, an RIA is required to fully disclose them. RIAs will work with you to develop a customized investment strategy based on your specific objectives and risk profile. However, it is important to only work with an RIA who can provide you with a verifiable investment track record.
At the end of the day, investors need to understand they are going to pay fees if they want their investment managed by someone else. The fact is fees do matter in the long-term performance of investment accounts. So, before you invest, make sure you know exactly what you’re paying.