One of the biggest mistakes investors make is paying far too little attention to the fees that investment managers and brokers charge them for the privilege of investing. The following scenario takes place every day in myriad settings and flavors.
“You get what you pay for.” That’s how Yechiel and Faigy Kroen’s financial adviser rationalized the significant fees built into the mutual funds he recommended. Being charged over 2% of their entire portfolio annually to managers and advisors seemed excessive to the Kroens. Faigy’s uncle had once mentioned in passing that the fees on his portfolio were well under 1%. On the other hand, the broker had shown them that despite the high costs, his recommendations had been top performers lately. If they grew faster than other mutual funds, who cared about high fees?
For many products and services, getting a lower price means settling for an inferior product, and “You don’t want to go cheap over here,” cautioned the broker.
Are the Kroens mistaken to be concerned about high investment fees? Should investors ignore mutual fund and advisor costs and focus only on past performance?
Do You Get What You Pay For?
The saying “You get what you pay for,” is at best only partially true. No one tries to pay the highest price they can for plane tickets, cars, plumbers, or a house, in the expectation of getting a better product or service. (While price is correlated with quality, it doesn’t equal it.)
When it comes to investments, however, the expression is even more suspect. In finance, you get what you don’t pay for, says John Bogle of Vanguard Investments, the world’s largest mutual fund company.
Every dollar that middlemen take from an investment reduces its return, transferring money from your pocket to theirs. Bogle estimates that as much as half of a potential investment’s growth ends up being consumed by the client’s “helpers,” so excessive fees are definitely something to be concerned about!
Same Investment for Triple the Cost?
Overpaying for investment management is different from paying too much for other services, because the desired outcome in finance is all about money. If two people used the best plumber in town, but one paid a much higher fee, he spent more money, but his pipes are just as fixed as the other guy’s.
With investments, however, if someone overpays for the service, their outcome (profit growth) will be worse than that of those with lower costs. For example, a popular mutual fund within retirement plans is American Funds’ EuroPacific Growth. Depending on your portfolio size and broker, the annual fee charged for investing in the EuroPacific fund ranges from 0.49% to 1.65%, or more than three times as much for the exact same investment!
Over time, those extra fees cost the overpaying EuroPacific investors a damaging 35% of their growth (due to the loss of compounding)! They only got what they didn’t pay for; the balance went to their brokers.
Large But Hard-To-See Fees
Fees clearly matter to investment performance, but owners often don’t know how much they’re paying because fees may be cleverly camouflaged or deducted directly from client accounts as lower annual returns. Another issue with investment expenses is that, unlike most services, whose prices are based on their complexity, portfolio fees accrue as a percentage of the amount managed, so costs grow along with the client’s account balance.
When the pot is small, this may be a good deal (2% of $10,000 = $200), but as the portfolio grows, investment fees can quickly become excessive (2% of $1 million = $20,000, outrageous in most cases). Investment managers act like super-partners and take a chunk of the whole account every year, regardless of how well their performance has been.
High fees may be reasonable if the advisor provides additional add-on services such as financial planning, tax advice, and hand-holding, but brokers playing down their concerns about fees is typically due to some combination of bias and ignorance.
Heavy Charges Slow Performance
But what of the advisor’s claim that the fees are worth it because they paid for terrific performance? Much research indicates that, typically, good investment performance is despite high costs, not because of it. According to mutual fund rater, Morningstar, the best indicator of a fund with good long-term returns is low fees.
And conversely, the worst way to select an investment is to base it on recent performance. There’s a reason why the fine print of every investment says that “past performance does not necessarily predict future results.” Entering a fund with significant recent gains usually means that you are buying high and headed for a disappointing future, especially with a fund burdened by a bloated overhead. A solid, low-fee fund is the best way to go in most cases.
A good analogy for how high investment fees kill good investment performance is a marathon where the athletes are wearing knapsacks weighing from 1 to 200 pounds. A champion runner wearing the heaviest burden may be able to lead for a short while, but over time, will almost certainly fall behind even the average runners carrying no weight. Solid mutual funds are today available at fees as low as 0% (!!!). Over time, the burden of fees at 2% or more overwhelms 99% all managers, regardless of current champion status.
Fancy Funds: Overpaying For Underperformance
Ironically, the most outrageous fees are charged to wealthy people who invest in “alternative” assets like hedge, private equity, and venture capital funds etc., hoping to achieve returns above what’s possible with humble mutual funds. These funds usually charge 2% of capital annually, regardless of performance, plus 20% of yearly profit. Real estate syndications largely fall into the same category carrying very large fee burdens which only are justified for the rare, consistently winning, managers.
This lopsided arrangement turns outstanding returns into just good ones (15% – 2%) * 0.8 = 10.4%), a medium return year into a poor one (8% – 2%) * 0.8 = 4.8%), and a negative return even worse (-3% – 2% = -5%). Alternative funds’ heavy fee burden is why, as a group, they’ve produced mediocre to terrible returns. The few random ones that produce huge returns from time to time are the bait, keeping the mice interested.
High-fee fancy funds are a heads-I-win-tails-you-lose arrangement, and many fund managers who fail rebrand and try again! Large investors, as greedy as small ones, are trying to identify the few true champions with consistently high after-fee returns. They are exceedingly rare, and once clearly recognized as financial geniuses, they usually don’t need or accept additional funds!
Keeping it cheap and straightforward works in investing, and humble mutual fund portfolios beat the 10-year performance of the multibillion-dollar college endowments despite (or because of) their high-priced consultants and hedge funds. Just because something costs more doesn’t mean it’s better.
Want to dig deeper?
Try these related articles
Beyond Track Records: Researching Real Estate Investment Managers
Sometimes, It’s Good to be Nosy: Researching Financial Advisors