Don’t be passive when managing investment costs

As you know, gains in your stock investments are not guaranteed, even though it may feel like it if you’ve been invested in the market for the last decade.  Looking at the last five years, the S&P 500 index has increased an average of nearly 17% annually, with only minor corrections along the way.  In fact the S&P 500 returns have been so consistent that most large cap equity funds haven’t been able to beat this performance. Over a five year period only 17.6% of large cap equity funds beat the S&P Index (see exhibit 1 below).  In other words, if you had simply invested in the S&P 500 index then you would have done better than the majority of professional stock investment managers. But that’s not the end of the story. Even if you had invested in a fund that tracks the S&P 500 index, you still could have under-performed depending on the fees you paid to the investment company that managed your money. 

What fees do I pay?

There are a number of different fees you can pay for having investment companies manage your money, including commissions paid for trading, fund expenses, sales loads, or administrative fees in a 401(k) or other employer-provided retirement plans. Although all of these fees are important and impact the net value of your holdings, I’m going to focus on the fund expenses for this article. Fund expenses, often represented as an expense ratio, are the cost for an investment company to operate a fund. The expense ratio is calculated by dividing a fund’s operating expenses by the average dollar value of its assets under management. Simply stated, this is the cost you pay for the fund to manage your money and is taken out of your return.  As an example, if your return in a given year was 10% and the fund’s expense ratio was 1%, your net return is 9%. Even small differences in these fees can really add up, especially as your money grows.

How do these fees affect my money?

As I mentioned previously, even if you invested in a passively-managed fund that tracks a major index like the S&P 500, the fees you pay will impact the amount of money you will get back from that fund. Here’s an example that will really drive home the point:

Exhibit 2 includes three actual investment funds that all invest in the S&P 500. Even though these funds have the same investment objective, the amount of money you would have made over the last five years would be very different depending on which fund you owned. Shockingly if you had invested $100,000 in Fund C, you would have paid $9,615 in fees over five years, far more than either fund A or B. Moreover, you would have kept over $13,000 more in your returns if you had instead invested in Fund A.  Even after paying capital gains tax, that’s over $11,000 in your pocket. That’s worth repeating… that’s a difference of $11,000 over five years depending on which S&P 500 investment fund you owned.

You may be asking why I included Fund B in this scenario. I included that fund because it was the fund option offered in my 401(k) retirement plan. While retirement plans will offer funds with different investment objectives, many do not offer options within the same objective, like investing in the S&P 500 index.  Although you may get a good option (Fund B), you may not get the best option (Fund A). My recommendation is to check out the funds offered in your employer’s retirement plan to see how they stack up. Your current employer-plan may be restrictive, but in the event you leave your employer you usually have the option of taking your money with you. You can roll the money into another retirement vehicle (e.g., IRA) using your brokerage account that will usually offer more and better investment choices.

Where can I find information about my investments?

If you are interested in finding out more information about your investment funds, there is a great free tool offered by the Financial Industry Regulatory Authority (FINRA). The tool provides details on investment funds and more importantly allows you to do a side-by-side comparison of funds.

Which funds provide the best returns relative to cost?

If you are considering investing in funds that track to broad equity market indexes, like the S&P, then I recommend that you first review my research on Fund Efficiency Scores.

Are robo-advisors a good option?

You may have heard the term “robo-advisor”. A robo-advisor is an automated investment service that actively invests your money based on information you provide, such as risk tolerance and investment time horizon. Since your profile is managed online and automated, it can be done with minimal human intervention resulting in lower expenses and fees. As “wealth-management platforms”, robo-advisors typically compare themselves to financial advisors, but offer much lower fee structures.  Most robo-advisors charge between 0.25% – 0.50% for basic digital services, but prices go higher for additional services, like regular access to human financial advisors.

In my view, robo-advisors have similar investment characteristics and objectives as target date funds. Both manage your money based on risk tolerance and time horizon. The question of value again comes back to return versus cost. Now that robo-advisors have a track record, the returns of these investment funds can be compared and evaluated against other investment options, thanks to The Robo Report from Backend Benchmarking. Exhibit 3 below shows how the different robo-advisors stack up against each other.

What the chart doesn’t show is how those funds performed against alternative investments. As an example, if you invested in target date index funds from Schwab over the same one-year period, your rate of return and costs would have been better than any of the robo-advised funds. As shown in exhibit 4, an investment in the Schwab Target 2050 Index Fund returned 18.76% with an expense ratio of 0.08%.

Interestingly, as consumers we are usually cost conscious when making a large investment, like buying a house or paying for higher education, but most of us have no idea what we’re paying to buy an investment fund or how much it will cost us down the road. Maybe it’s because the fees and costs are ‘hidden’ in the returns. Your investment portfolio may likely be the biggest asset you own in your lifetime, so how much it costs you should be a major factor in what you decide to buy and hold.


Note: Past performance does not guarantee future performance. The findings contained in this assessment are for informational purposes only and should not be construed as investment advice or a recommendation to buy specific investments.

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