A 2% mutual fund fee can cost you over $1.3 million over a 40-year investing lifetime.
You may say, “How can that be … the annual Management Expense Ratio (MER) is small, only 2%!”
You are right. It does seem small.
But the fee induces a non-intuitive “drag” that hinders compound growth.
With low-cost index funds, you reduce the money skimmed off by the financial services sector and maximize your wealth.
Here is the effect of fund fees on your long-term wealth if you invest $1,000/month for a set period. I assume the underlying index returns 8% annually before fees.
Table of Contents
What's A Fund?
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 receives a salary to buy individual stocks and bonds; there is record keeping, transaction costs for stock/bond sales and regulatory adherence. The people who perform this work require office space.
Why Invest In A Fund?
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.
You may say, “Why not just invest in individual stocks to avoid fees?”
It’s hard to be successful by picking individual stocks.
Very hard, as reflected by the fact that 94% of US mutual funds underperformed the market (after-fees) over the past 15 years ended 2022 (source).
Only 1.3% of stocks account for the total stock market wealth creation above cash-earning interest (three-month treasury bills).
Assessing, buying and monitoring hundreds of individual stocks and bonds on your own is super time-consuming.
These are the reasons investors own funds.
How are Fund Fees Expressed, 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
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.
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 your broker charges 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. Intuitive.
(2) Money lost 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 the effect 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.
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
The outcome is not pretty when you layer high fees on top of inflation.
For example, global stocks have returned 8.3% annually for the past 122 years (source).
Over the last 100 years, inflation has run at 2.7%. Inflation-adjusted returns are now 5.3%.
In an efficient market, any given fund can be expected to get the market return before fees.
With a high MER of 2%, the after-fee reduces your return from 5.3% to 3.3%.
The 8% annual return generated by underlying global businesses dropped to 3.3% 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 buy stocks 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.
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 and funds must get the market return, represented by a total market index. 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 shared between investors and 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.
Conclusion
- 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.
- Even for professional fund managers, market efficiency makes it hard to beat the market.
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