Do you ever wonder how fund fees impact your long-run wealth?
I was thinking about this recently, and I realized that the total effect of fund fees is not intuitive. Therefore, I decided to crunch some numbers in excel and write this post.
The easily understood part of fees is the annual fee itself, equal to the Management Expense Ratio (MER). But the MER does not tell the entire story.
Fees also induce a non-intuitive “drag” that hinders compounding. This has a huge effect on long-term wealth, especially over a lifetime of investing.
In this post, I’ll show you how fund fees impact your long-term wealth. I believe this can help you make informed investing decisions.
First, I’ll start with the two ways fund fees can hurt your long-term wealth.
Table of Contents
What's A Fund?
First, I want to clear up a key definition. A fund is a collection of individual stocks or bonds owned by a group of investors. Funds come as mutual funds or exchange traded funds (ETFs).
It costs money to run a fund. The fund manager is a human who gets a salary to buy individual stocks and bonds, there is the paperwork needed to track the fund and regulatory requirements that must be adhered to.
When you buy individual stocks and bonds, you do not pay fund fees. However, you will pay transaction fees unless you’re with a commission-free brokerage.
If you can just buy stocks for free, then why buy a fund and absorb fund fees?
Why Invest In A Fund?
By pooling your money with other investors, funds allow you to own a sliver of hundreds (or thousands) of different stocks and bonds.
It’s hard to be successful by picking individual stocks.
A tiny number of stocks account for nearly all the returns, and they are difficult to find ahead of time.
Then there is the fact that you need to pick a ton of stocks to diversify away risk that you don’t get paid for (company-specific risk). More on risk in this post.
It is super time-consuming to assess, buy and monitor hundreds of individual stocks and bonds on your own.
These are the reasons investors own funds.
How Are Fees Expressed and Where Do They Go?
Fund fees are expressed as an annual percentage of the amount you have invested. It is called the Management Expense Ratio (MER).
For example, you pay $200 per year when you invest $10,000 in a fund with a 2% MER.
These fees are used to pay the fund manager, who invests in assets like stocks and bonds, and to cover other operational and administrative costs associated with running a fund. Sometimes the fees include services like financial advice.
To show where fees go, here is a fee breakdown below from RBC that shows a more detailed outline of a typical MER.
To be clear, taxes included in the MER are not taxes on investment income. You still pay taxes on your investment income (dividends, capital gains or interest).
The fees are paid through a reduction in the value Net Asset Value (NAV) of the fund. So, you don’t pay fund fees directly. Instead, fund fees are paid indirectly by reducing your capital gains and dividend payments.
You can read more about the NAV in this article.
The main thing to know is that the fees reduce your total return by reducing fund distributions or reducing the value of the fund.
Other Fund Fees
For mutual funds and ETFs, there are other fees in addition to the MER. I am these fees in this article.
Mutual funds often include expensive (and sneaky) sales load fees. I only invest with ETFs, so I don’t have a “need to know” for sales load fees.
Since I don’t like writing about things I don’t understand, I’ll refer you to this article to learn more about mutual fund load fees. Check out the part on “shareholder fees”.
For ETFs, you also have trading fees that are charged by your broker every time you make a trade. This fee comes in addition to the MER.
The trading commission you pay is unique to your brokerage, and may not apply if you use a commission fee broker like Wealth Simple Trade.
The Two Ways Fund Fees Hurt Long Term Wealth
There are two ways that fund fees hurt your long-term wealth:
(1) You lose the money paid directly as fees, equal to the MER, and paid annually.
(2) Your money paid as fees can no longer compound in the future. This is a non-intuitive “opportunity cost” that has a large impact on long-term wealth.
For point #2, the effect on end wealth is small over short time periods, but it balloons over large time horizons.
I’ll show this through an example.
Example: Long Term Wealth Erosion From A 1% Fund Fee
Consider what happens when you invest $1,000 per month for 30 years in a total market index fund.
I assume the underlying index provides an 8% annual return, and that the fund fee is 1%.
This table tells the story.
The 1% fee reduces your 8% return to a 7% return. At year 30, the wealth difference between a “no fee” situation and a 1% fee situation is $255k.
Interestingly, you paid $150k in fees but lost $255k in end wealth. Why the difference?
The difference ($105k) was due to lost compounding (factor #2 above). Fees paid early on could not compound in the future, resulting in an opportunity cost of $105k.
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The Long-Term Effect of Fund Fees
This chart shows the difference in final wealth before and after fees when investing in a market index returning 8% annually.
I assume you invest $1,000 per month and show different MERs and time horizons.
You can see that time is a massive factor.
Time influences compounding, where tiny changes in parameters (fees) have huge effects on your final wealth.
This effect is non-linear, and is therefore non-intuitive.
Free Fund Fee Calculator
You can access my fund-fee calculator below, where you can plug and play different numbers to estimate your lifetime losses to fees.
High Fees And Inflation: A Costly Duo
Fund fees aren’t the only return killer. Inflation also erodes returns.
When you layer high fees on top of inflation, the outcome is not pretty.
For example, global stocks have returned 8% annually for the past 122 years (source).
Over the last 100 years, inflation has run at 2.7%. This brings your returns down to 5.3% after inflation.
A fund that invests in global stocks can be expected to get the market return, before fees.
You can see why this is the case in my post on market efficiency. It’s super hard to beat the market, including for professional funds.
With a high MER of 2%, the after-fee expected return drops to 3.3%.
The 8% annual return generated by underlying global businesses dropped to a 3.3% annual return after fees and inflation. Ouch.
Together, fees and inflation erode long-term wealth.
How To Avoid High Fund Fees
There are two ways to minimize high fees. You can either buys assets individually, which eliminates the need to use a fund, or you can look for low-cost funds, such as total market index funds.
I use low-cost index funds because I know I can’t beat the market, and I know that total market index funds maximize risk-adjusted returns.
I’ll talk about why total market index funds have low fees.
But first, here are two relevant articles to learn more about index funds:
Index funds have low fees due to scale and simplicity.
Scale reduces fees by spreading costs over many investors, thereby reducing the cost per investor.
Simplicity limits the buying and selling of assets held within the fund (turnover). The low turnover reduces management complexity, thereby reducing MERs. Low turnover also increases your tax efficiency.
Because of simplicity and scale, index funds reduce fees. The index ETFs I use have fees ranging from 0.06% to a maximum of 0.2%.
The Source Of Returns: Fees Are A Drag, In Aggregate
In aggregate, investors must get the market return. This is a fact.
When individuals or institutions outperform the market, it comes at the cost of other investors who underperform. For every winner (above the market return), there is a loser who underperforms.
With this in mind, you can expect the total group of funds to get the market return, before fees. Therefore, after fees, you can expect funds to underperform the market.
The aggregate underperformance would equal the average fund fees, weighted by fund size.
There is another way to view this. I’ll start with the fact that returns stem from the collection of businesses that undergo earnings growth and produce dividends. See more in my post on Where Stock Returns Come From.
The returns produced by the source (businesses) are reduced when they pass through the financial services industry. You, as the individual investor, see the final amount.
Low fees minimize wealth skimmed off by the financial sector and maximize wealth in your pocket.
Why It Is Hard To Beat The Market
Thanks to market efficiency, very few individuals or funds consistently beat the market over the long term.
In fact, SPIVA shows that over 80% of actively managed funds underperform their benchmark index after fees over a 10 year period.
The 20% of funds that outperform the market don’t tend to outperform going forward. Past performance is a poor indicator of future performance.
Market efficiency is the reason it is so hard to beat the market. Most available information is priced into individual stocks and bonds.
Similarly, fund manager skill is “priced in” to the fund share price. The future return acquired by individual investors is expected to equal market return, minus fees.
Overall, it’s worth asking if it is worth your time an energy to try to beat the market. If not, funds are worth consideration. Beware of fees and performance data for actively managed funds.
- Fund fees apply to mutual funds and ETFs, and are stated as an annual Management Expense Ratio as a percent of the amount you have invested.
- Fees erode your long-term wealth, especially over long time horizons.
- Market efficiency makes it hard to beat the market, even for professional fund managers.
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