Fund Fees: Nest Egg Killer

Apr 23, 2012 by

Regular readers know I’m a bit wary of Wall Street generally and “money managers” particularly. (Take a look at my Must I Own Stocks? and Buyer Beware Applies to Wall Street posts to learn more.) I tend to think of Wall Street in the same way I think of Las Vegas: The players can make money, but the really big, consistent winners are the owners and managers of the game, whose foremost objective is to keep the game going and growing.

Wall Street & Vegas: Imperfect (but Fun) Comparison

The Wall Street/Las Vegas analogy only goes so far of course, but I think is still useful. Unlike a craps table bet, when you buy a stock, in theory you’re investing in the skill and talent of a company’s management and workforce to bring to market quality products or services that people will want to buy. Think of Apple at one end of the spectrum, and perhaps Pets.com at the other. If you believe generally that standards of living and average incomes will continue rising globally, or that certain trends will emerge and become dominant, then you can invest in that growth and opportunity by buying the stock of companies who are poised to benefit.

(For simplicity, I’m ignoring here the many, many ‘games’ Wall Street has invented that permit bets to be made on virtually any economic eventuality. Do you think China’s going to crash? There’s a game for that. Do you expect Spain to default on its sovereign debt? Come right up to the table, you can make a bet on that outcome. Over the past thirty years, managing investments in companies expected to prosper over time has become almost a quaint side business for Wall Street firms, not nearly as sexy—or lucrative—as derivatives, high-frequency computer trading, or making financial bets against one’s own customers, to name just a few.)

Enter the Actively Managed Mutual Fund

But someone stands between you and your just rewards as an investor in promising corporations: The people running actively managed mutual funds. What’s an actively managed fund? Actively managed funds employ human judgment to choose companies into which the mutual fund’s shareholders’ money is invested. In contrast, passively managed funds are designed to mimic the performance of, typically, a particular index, like the S&P 500. Computer programs control a passively managed fund’s holdings and make sell & buy decisions.

While computers and computer programmers aren’t free, they cost a pittance compared to a Wall Street money manager. (The average cash bonus on Wall Street was $121,150 in 2011, a bleak year for money manager compensation.) When you buy shares in an actively managed mutual fund, you’re paying for money managers. Are they worth it? I’ll start an argument: No, money managers are not worth their cost.

The Impact of Mutual Fund Fees on Your Nest Egg

Here’s a simple graph to show the dramatic affect of fund fees on the growth of an investment.

Imagine you invest $10,000 in a mutual fund and earn 6% per year for 10 years. With no fees at all, you’d have $17,908 in your account at the end of the decade—see the far left end of the line.

mutual fund fee impact on $10,000

A 1.5% mutual fund fee negatively impacts a $10,000 investment by $2,512 over 10 years.

But look what happens as annual mutual fund fees rise. With just a 1% annual fee, your final account balance would be $1,712 (9.6%) less because you’d have paid someone to pick stocks for you (assuming we’re talking about a stock mutual fund here).

With a 2% annual fee, you’d finish the decade with only $14,633, reflecting a $3,275 hit from the impact of fund fees. The 2% annual fee would slash your 10-year return from 79% to 46%, a retirement-busting 42% negative hit. Now imagine expanding this effect to your entire retirement nest egg. Oh well, maybe working until age 75 won’t be so bad.

How Are Fund Fees Relevant to the Passively vs. Actively Managed Mutual Fund Choice?

Passively managed fund fees are much lower than actively managed fund fees. For example, the expense ratio (what I’ve been calling a fund fee) for the passively managed Vanguard Total Stock Market Index fund is 0.18%, way over at the juicy left end of my graph. According to Vanguard, this compares to an industry average of 1.12%. And according to Motley Fool, the industry average expense ratio for actively managed funds is about 1.5%.

Why Do Actively Managed Mutual Funds Exist, and Why Do Loads of Investors Buy Their Shares?

There’s a clear answer to this question: Because a lot of people make a lot of money selling actively managed mutual funds, and these people spend a lot on marketing. And because the continuous parade of phonies and quacks on media like CNBC have concocted the Grand Illusion that some, ‘special’ humans are able consistently to predict and parse the fortunes of corporations, countries, and currencies.

The Case for Actively Managed Funds

I can think of only one conceivable argument for investing in an actively managed mutual fund: The fund’s stock-pickers are so bright they can overcome, through consistently better performance than a low-cost index fund, the downward slope of my graph above and so justify their cost.

Lots of actively managed funds beat passively managed funds in any particular year. But if anyone out there knows of an academic (I purposely do not say money management industry) study demonstrating consistently better performance—after fees and taxes—of any actively managed stock fund versus, say, an S&P 500 or Total Stock Market index fund, please educate us in the comments to this post.

Sure, over any given, relatively short period of time like a year or three, you’ll find actively managed funds focused on tightly defined niches that perform very well, much better than any passively managed fund. You’re probably smarter than me, but I suspect I’m not clever enough to choose the right niches for the right periods of time to conclude that, at the end of the day, I’ll be better off buying niche-focused actively managed funds instead of passively managed funds.

Further, I’m bothered by the total lack of a direct connection between fund manager compensation and fund performance. A fund’s expense ratio isn’t connected to the fund’s performance. Back here in the real world, performance matters.

What Do You Think?

I’ve staked out a lot of contentious territory in this post. Please make the case for actively managed funds in the comments. Or send me a guest post—I will publish a well reasoned argument, even if I’m not personally persuaded by it. And who knows, you might change my mind. I’ve been wrong at least thirteen times already today!

What’s your judgment about passive vs. actively managed funds? Have you made a killing in an actively managed fund by being in the right place for the right period of time?

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  • http://shortroadtoretirement.com/short-road-portfolio James

    Over the long term, most investors are better off with index funds.  Carefully selecting a diversified portfolio of 5 star rated Morningstar funds can outperform the indexes.  The issue is, most investors don’t have the knowledge to construct a diversified portfolio of funds.  

  • http://squirrelers.com/ Squirrelers

    I think actively managed funds can be a fool’s game.  It’s interesting how just keeping money in an index fund can outperfrom “professional” management, but it can be the case. 

    Clearly, people don’t always get what they pay for. Worse, they can get punished for paying! Every percentage point can make a real difference over the long term.

  • http://mymoneycounselor.com/ Kurt Fischer

    @8134375f156c80c7973c643ac94b05cd:disqus  – would you mind sharing your 5-star portfolio with us?
    @2da1d1e388c8c85193640e6f8ac10db0:disqus Yes, a percentage point is gold over the course of one’s prime working & earning years.
     

  • http://www.pfblogwatchdog.com/ Bichon Frise

    I believe there are fund managers out there that are extremely bright and have the skills to beat the market consistently.  The example is Peter Lynch and what he did with his Magellan fund for 13 years, avg 29% annual return.  If you invested $10k in Peter’s fund when he took over in 1977 until he retired in 1990, you would have ~$255k vs $65k in an S&P 500 index fund.  So, there are people who have beat the market consistently.

    Unfortunate for us, we only know ex post (after the fact) who is good and who is lucky.  But, we have to make our decision ex ante.  So knowing ~62% of actively managed funds don’t beat their index (5 yr avg return) before fees, even if you are holding the other 38% of the funds that do beat the index, you are more likely be “investing” in a fund manager that is lucky (can’t deliver over the long term) rather than good (can keep up performance over the long-term).

    So give me the more sure thing, the low fee index funds.  I don’t have the stomach for active funds.  Sure, I may be missing out on excess returns, but I’ll play the numbers and reduce my risk.       

    • http://mymoneycounselor.com/ Kurt Fischer

      I agree with you about Lynch. I have a friend who retired at age 41 due largely to his investment in Magellan. But I think the Peter Lynchs and Warren Buffetts of the investing world are about as common as the Einsteins and Heisenbergs in the physics world. Thanks for your input.

  • http://twitter.com/Shilpan Shilpan

    Amen! This post transpires my belief about the Wall Street so nicely. I firmly believe that mutual fund lobby wants average American to keep investing in mutual funds without knowing the actual cost. They use CNBC and other media outlets to sell their propaganda to the masses. I wish everyone reads this article. I am going to tweet. Thanks for sharing. 

    • http://mymoneycounselor.com/ Kurt Fischer

      Thanks for your endorsement and support!

  • http://www.101centavos.com/ Andrew @ 101centavos

    So, not just a “talented” manager, but a small army of researchers, admins and marketers. No wonder it’s 2% (and other assorted fees) versus a fraction of a percentage point for ETFs.

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