About the High Cost of Mutual Funds
. . . And What You Can Do About It
Imagine a race where your horse has a 20-pound jockey and the others have 100-pound sometimes even 200-pound jockeys. Guess which wins.
This is how it works with mutual funds. Some have 20-pound jockeys. Most have 100- and 200-pound jockeys – high fees and taxes that weigh down performance. Over the long run, this makes a HUGE difference. Because in reality …
… Most People and Mutual Funds Do Worse Than Average
It is maddeningly difficult to “beat the market.” Indeed, most people and most mutual funds actually do worse than the market averages each year, for a very simple reason: the averages are just that – theoretical, numerical averages. They pay no brokerage commissions, they pay no fees, they pay no taxes.
What Counts Is How Well You Do After Costs
If the stocks in your mutual fund were up 10% some year, that’s fine – but how much were you up? There are fees, transaction costs and taxes if outside a tax-sheltered retirement plan. As you can see from our calculator, in reality 10% could be cut to 7% or less!
A Little Difference Becomes a Very Big Difference
Over a lifetime, even 1% makes a huge difference. If you put away $2,000 a year for 50 years at 8%, you’d have nearly $1.25 million at the end. Not bad. Doing just 1% better, though, you’d come out more than half a million dollars ahead – just north of $1.75 million.
Focus on Costs . . .
. . . Because Predicting Costs Is Much Easier than Predicting Performance
Decades of research have shown that superior past performance generally does not “persist,” but that inferior past performance, when caused by high costs and taxes, generally does.
In summary, the familiar disclaimer that “Past performance cannot guarantee future results” should really read, “Past performance simply does not predict future results.” Except when it comes to costs.
What Are the Costs and Why Do They Matter?
There are four basic kinds of costs associated with owning mutual funds:
- Management Fees: paid to the company that manages the investment portfolio
- Distribution Fees: paid to the broker or adviser that sells the fund and services the account
- Transaction Costs: incurred by the fund as it buys and sells securities and are not incorporated in a fund’s “total expense ratio.” They are taken directly out of shareholder assets.
- Taxes: The fund itself does not pay taxes. Shareholders who own the fund in taxable accounts pay taxes on dividends and capital gains distributed by the fund.
But Don’t You “Get What You Pay For?”
It would be different if the funds that charged the highest fees could justify them by turning in the best performance. Who wouldn’t be willing to pay 1% or 2% a year more for a fund that could beat the market by 5% or 10% a year?
In practice, there’s no evidence that higher-cost mutual funds earn higher returns than their competition. Quite the contrary.
Yes, some funds excelled last year. But – counterintuitive though it is – this tells you little or nothing about how well they will do next year. Bottom line, the easiest way to assure reasonable investing success is to focus on costs.
How Much Can I Realistically Expect to Earn?
At times when the market gains 20% or more in a year . . . and when companies going public can double on their first day of trading . . . it’s important to realize that the true long-term rate of return on U.S. stocks, after tax and inflation, has historically been only 3% – 5% per year.
I tell you this not to depress you, or even to help you make more realistic retirement-planning assumptions, but to bring into still higher relief the relative importance of an extra 1% or 2% in costs.
The Appeal of Passive Investing
It is for precisely this reason that many smart people today don’t try to beat the market. They merely try to match it, or close to it, by buying and holding a broad cross-section of stocks. This strategy is called passive investing, and it outperforms most actively managed mutual funds – especially in taxable accounts.
Ironically, most people who try to “beat the market” end up with mediocre results, while those who merely try to match it outshine the average investor.
Index Mutual Funds and Exchange Traded Funds (ETFs)
The easiest way to invest passively is with index funds or ETFs that track a large set of stocks, such as the S&P 500 or the Wilshire 5000. This is so easy to do that it can be done at very low cost.