YOU CAN INVEST on the cheap, but nothing is free. And the cost can make a big difference to your long-term bottom line.
When you choose a mutual fund, you’re paying the company that invests on your behalf. And that company should be paid for its services.
But if you pay too much, those fees will eat into your long-term returns, potentially taking thousands of dollars from your portfolio.
“Investment fees of all kinds are important for long-term planning because of the power of compounding,” says Hugues Rivard, a certified financial planner and self-proclaimed math geek with Financial Life Focus in Livingston.
“People may believe that a difference in investment return of 0.5 percent annually is not that significant, but over a 20- to 30-year period, it becomes very important.”
Smart investors consider fees as part of the mutual fund selection process.
Here’s a primer:
COMPARE APPLES TO APPLES
Every mutual fund charges an “expense ratio,” which covers the costs of trading and managing investments within the fund. Different kinds of mutual funds will have expense ratios of varying amounts.
Index funds, which basically buy and hold stocks in an index, don’t require much trading or managing, so they have smaller expense ratios than so-called actively managed funds, which have a wide variety of fees.
“Some funds trade more stocks inside of the fund,” says Alan Meckler, a certified financial planner with Cornerstone Financial Group in Succasunna. “International, emerging markets and small company stock funds have higher expenses because they typically require more research and have higher turnover.”
When you compare mutual fund fees, make sure you’re comparing apples to apples, or funds within the same asset class.
So, what’s a fair fee? You have to consider the averages.
According to Morningstar.com, the average expense ratio for an actively managed U.S. stock fund is 1.25 percent, compared to 0.75 percent for passive U.S. stock funds. That would include index funds.
When you consider what the fund invests in, average costs vary.
U.S. large-cap funds average 1.16 percent, while small-cap funds average 1.32 percent, Morningstar.com says. International stock funds average 1.21 percent.
The costs rise when you get into specialty sector funds. Domestic real estate funds average 1.33 percent, while tech funds average 1.52 percent and energy funds average 1.54 percent.
MATH FROM THE MATH GEEK
Here’s how a higher expense ratio matters over the long term, according to Rivard.
Let’s say you want to invest $100,000 for 20 years and you’re choosing between two mutual funds that will have the same gross return of 7.33 percent a year. Not bad.
But now, the fees. Fund A has an expense ratio of 0.33 percent, while Fund B has an expense ratio of 1.33 percent.
The net returns, after fees? Fund A had a return of 7 percent while Fund B had a return of 6 percent.
“At the end of 20 years, the investor would have $386,968 if Fund A was used, and $320,714 if Fund B was used,” Rivard says. “That’s $66,254, or 21 percent, more by using Fund A.”
That could make a big difference to an investor’s retirement nest egg.
Expense ratios aren’t the only fee to consider. Some funds charge what’s called a “load,” a commission that goes to the salesperson. Others charge a commission when you sell the fund.
When you buy a front-loaded fund — one for which the commission is due upon purchase — that fee is deducted from the amount you invest. So if you planned to buy $1,000 of a fund, and it has a 5 percent load, you’re really investing $950.
Instead, Rivard said, investors should look for no-load funds. “There are plenty of good funds available where the expense ratio is under 1 percent. Anything above that is probably an actively managed fund, and those have generally not performed very well over longer time horizons.”
WHEN FEES ARE WORTH IT
It’s easy to compare fees hypothetically because you can assume the funds you’re looking at have earned the same return, but that doesn’t always happen in the real world.
So, if you’re looking at a fund that charges a higher expense ratio than average, this doesn’t automatically mean you should steer clear. Again, check the numbers.
“The fees take away from the overall return, so by keeping fees in check, your portfolio will have better returns, all things being equal,” Meckler says. “However, if a fund charges 3 percent in fees and outperforms all the other funds in the same category by 3 percent, then the higher fee is worth it.”
So, be sure not to ignore returns when you examine fees.
Karin Price Mueller, the founder of NJMoneyHelp.com, writes the Bamboozled consumer affairs column for The Star-Ledger, and the Money and Biz Brain columns for Inside Jersey. Send your money questions to her at Bamboozled@njadvancemedia.com.