The Secret to Higher Returns

The costs you pay for your investments can profoundly impact your returns, especially over the long term.

This observation from Vanguard is spot-on: "If the money is going somewhere else, it's not going to you."

You pay many different costs.  You may not even be aware of some of them. The secret to higher expected returns is reducing these costs. Here is a rundown of the cost of investing that reveals the secret to higher returns.

The impact of fees on returns

While we know the positive effects of compounding returns, the same is true of your investment-related costs compounding over time. 

Here's an example:  If you invest $100,000 in a fund with an average annualized return of 6% and low management fees of 0.5%, you'll end up with $291,776 at the end of 20 years.

The total gain on that portfolio was actually $220,714, but you lost $28,938 when you combined the fees paid and the lost earnings you would have made if those fees had been invested.

If the fees of the mutual fund were 1% instead of 0.5%, you'd end up with $265,330 at the end of 20 years.  The total gain on your portfolio would still be $220,714,  but you would have lost a stunning $55,384 when you combine fees paid with the loss of earnings you would have made if those fees had been invested.  Now, the 0.5% differential in fees does not seem so insignificant. This shows that low fee investments impact returns. 

Lower fees mean higher expected returns

We are all familiar with the adage "you get what you pay for." Unfortunately, it doesn't apply to mutual funds.

Research on mutual funds has shown that high-cost funds often generate a lower return than low-cost funds.  A study by Morningstar found that "low-cost funds tend to lead to higher total returns and higher investor returns."

The management fees charged by mutual funds can be a valuable predictor of a fund's returns, with lower fees correlating with higher expected returns.

Fees, fees, and more fees

Some fees you incur with your investments are transparent; others are hidden. You need to be aware of all of them, especially that low fee investments has impact on higher returns. 

Here are the most common ones.

1. Expense Ratios (Mutual Fund Fees)

An expense ratio is often charged when you invest in mutual funds.  It is a percentage of Assets Under Management (AUM) that is charged yearly by mutual funds.  

For example, if the fund has an expense ratio of 0.5%, for every dollar you invest, 0.5% is deducted as fees.  So, if you invest $1000, only $995 is invested, and the $5 deduction is the fee.  

Most mutual funds list their expense ratios on their Fund Prospectus or website.  It is important to compare similar funds and their expense ratios when you invest, as they can vary significantly.

A fund's total expense ratio also includes management fees, which are costs related to operating and maintaining the fund—hiring a professional investment team, marketing expenses, and legal and administrative costs to ensure adherence to laws and guidelines.

Passively managed funds like index funds typically have low expense ratios because they simply track the returns of a benchmark index and have low costs. 

Actively managed funds generally have high fees because fund managers incur great costs to evaluate and select stocks they believe will beat the returns of the benchmarks. 

A 2020 study by the Investment Company Institute found that, on average, the expense ratio for actively managed stock mutual funds was 0.74% in 2019, while index funds had an average expense ratio of just 0.07%.  This difference in fees makes it difficult for actively managed funds to beat the returns of comparable index funds, especially over the long term and after taxes.

2. Trading or Transaction Costs

When fund managers buy and sell securities for the fund, they incur trading costs (commissions paid to a broker to carry out a trade) which are passed on to investors.  The more actively a fund trades, the higher the costs.  

These costs are in addition to the management fee charged by the mutual fund.  

3. Front-end and back-end loads

Some mutual funds offer different classes of shares.  Each class invests in the same portfolio of stocks but with different fees and expenses.  

Class A shares of a mutual fund typically charge a front-end sales load, which is a fee investors pay when they purchase fund shares. 

Class B shares may charge a back-end sales load, which is a fee investors pay when they sell their shares.  The amount varies and typically decreases the longer the shares are held.

Class C shares may charge either a front-end or back-end sales load.

4. Other mutual fund fees

Some mutual funds charge 12-b-1 fees to cover distribution and shareholder service expenses. 

Distribution fees are intended to cover marketing and related sales expenses.

5. Advisory Fees

Advisory fees are the costs incurred for hiring a financial advisor, usually charged as a percentage of assets under management, similar to how mutual funds charge management fees. 

When you aggregate all these costs, it's easy to see how they impact your returns over time.

Darrell Armuth founded Sensible in 1994. Since then, he has served hundreds of clients. Darrell is a Certified Public Accountant certified by the state of Nevada.