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  • Writer's pictureHugh F. Wynn

The Case Against High-Fee Mutual Funds

According to a survey by the Investment Company Institute, a fund trade group, 22% of households that own mutual funds said the fees and expenses they pay “are not very important” or “not at all important”.

Despite a major shift by mutual fund providers in recent decades to low-fee options, a surprising 21% of all U.S. Large Cap funds still have expense ratios above 1.5% (source: Morningstar, Inc.). Notably, many of these same high-fee funds also have elevated levels of risk and a portfolio turnover of double the low-fee options. High portfolio turnover invariably leads to higher tax bills associated with the inevitable increase in short-term capital gains.

I Pay Fees?

According to a survey by the Investment Company Institute, a fund trade group, 22% of households that own mutual funds said the fees and expenses they pay “are not very important” or “not at all important”. In a study commissioned by the US Securities and Exchange Commission (SEC), 25% of investors said they didn’t even know which types of fees they pay (while 20% said they didn’t pay any fees at all – yeah, sure). I shudder when I read tidbits like this. And I’ll show you why using some examples.

Studies indicate that investors – busy… or apathetic – seldom get what they pay for when buying “high-fee” mutual funds. A January 2019 Wall Street Journal article by Derek Horstmeyer, an assistant professor of finance at George Mason University’s Business School, sheds light on the detrimental long-term costs of high annual expense ratios (expense ratios are the annual fees expressed as a percentage of assets under management) that accompany many actively managed mutual funds – expense ratios often associated with “some of the worst performing, most poorly managed funds especially in the U.S. Large and Small Cap Fund categories”.

High Fees: Worth the Cost?

Although that “increased” annualized yield for investing in a low-fee fund (one charging less than 1.5%) versus a high-fee fund (over 1.5%) is largely an across the board phenomena, it is particularly noticeable in the U.S. Large Cap category. Over a 10-year period through the 3rd quarter of 2018, the high-fee category delivered an average annual return of 10.61%, after expenses, while the low-fee option delivered 12.26%, a positive difference of 1.65% percentage points.

The underperformance of high-fee funds was even more pronounced when considering the category of funds charging a ratio of 2.0% or more. In this case, the 10-year high-fee fund yield fell to 10.01%. The underperformance of high-fee funds impacted other asset classes, too, but to a lesser degree. In the case of U.S. Small Cap stocks, the average 10-year overperformance of low-fee funds was .73% points and for International Equity funds, 1.10%.

And The Dollar Cost Is…?

To illustrate the potential financial penalties associated with high-cost funds, let’s use a simple hypothetical of a high-fee investment of $10,000 increasing at an annualized rate of 5.35%, compounded annually during a 40-year career. After 40 years, the initial onetime investment of $10,000 would be worth about $84,000. Using the same assumptions but changing the annualized rate to 7.00% (to reflect a reduced fee of 1.65%), the low-cost fund would be worth over $160,000 after 40 years, a dollar improvement of $76,000… almost double the high-cost fund. As noted earlier, that 1.65% improvement in yield (due strictly to reduced fees) during a 40-year career can be really significant.

Vanguard’s founder, John Bogle, often said, “The grim irony of investing is that, as a group, investors not only don't get what they pay for, they get precisely what they don't pay for." In short, every dollar you save by investing in a low-cost, unmanaged index fund is a dollar of return that benefits you, not some fund manager.

Burning Free Money

To ignore the realities of investing in high-fee versus low-fee mutual funds is a mistake as egregious as not optimizing a 401(k) plan employer match (FREE MONEY) at your workplace. I wouldn’t call such an action foolhardy, but I will be so bold as to call it a bullheaded pursuit of a costly million-dollar habit.

My motive for pointing the Horstmeyer study to a wider audience is purposely transparent. It’s another incentive to build a portfolio of funds around a low-fee, broad market index fund – or perhaps, simply stick with an all-index fund portfolio.

In any case, always try to invest at the lowest possible cost.

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