The Dirty Little Secret of Mutual Funds

Posted on Posted in Investing, Retirement

Mutual funds have a dirty little secret, and they want to keep it that way.

The secret costs us thousands and prolongs our inability to achieve complete financial freedom.

But we can beat it and I’ll show you how!

The Dirty Little Secret

Have you ever gone to a car dealer, found the car you wanted, and tried to buy it only to find out that all sorts of other fees have been tacked onto the final negotiated sales price? It’s frustrating isn’t it?

Well, that’s a lot like how the financial industry works, but unlike the car dealerships, the financial industry never really shows us all the charges that have been added to the final pricetag—it’s their dirty little secret.

That’s right. Mutual fund companies never show us how much we’re actually paying for the funds we purchase.

Financial brokers and the representatives that help set up our 401(k) plans recommend various actively managed mutual funds (a collection of diversified investments that are professionally managed), and most of us have no idea how much the investment cost or the toll it is taking on our financial future—we’re just happy we’re saving money when in reality, we’re missing out big time.

That’s about to change!

These actively managed funds have high fees. And big fees for us means big pay days for the financial professionals.

This is why the mutual fund industry has exploded in size—those selling them can make a killing.

There are currently more mutual funds than there are stocks. In fact, actively managed mutual funds are so popular that in North America, there are more than 10,000 funds totaling nearly $13 trillion worth of our savings.

Overview of the fees

The average cost of owning a mutual fund is 3.17% per year! You’re essentially paying $30+ for every $1,000 you have invested.

Now if that doesn’t seem like a lot, just realize that these fees compound over time and there are superior investments that cost closer to 0.15% or $1.50 for every $1,000 invested. In other words, actively managed mutual funds are more than 20 times, or 2,000% more expensive than the superior index funds I recommend (See The Best Way To Invest In the Market).

There are essentially 11 different fees that dig into our invested savings.

Here’s a quick summary:

1. Expense Ratio. The expense ratio is the “price tag”  and it normally costs us between 0.9% and 1.31% of the amount invested per year. This is usually the only expense any of us know about, and it’s used to pay marketing costs, distribution costs, and management fees.

2. Transaction Costs. This expense covers brokerage commissions, market impact cost, and spread costs. According to a study by business school professors Roger Edelen, Richard Evans, and Gregory Kadlec, on average, transaction costs run 1.44% per year. This means that transaction costs are likely our highest fee, but they are never disclosed since the financial industry has deemed that they are too difficult to determine. Sounds like they should be in the lobbying business rather than investing.

3. Tax Costs. Every time a fund manager sells a stock that has appreciated, we pay taxes. Here’s the crazy thing: we could be hit with a tax bill even if we never benefited from the appreciation. If any of us buys into a mutual fund that holds stocks that have appreciated prior to our purchase of the fund, we could be hit with the tax bill. Essentially, we are paying taxes on something we never benefited from. According to Morningstar, the average tax cost ratio for stock funds is 1% to 1.2% per year.

4. Soft-Dollar Costs. Soft-dollar trading is essentially kickbacks or rewards for mutual fund managers for using particular vendors. Mutual fund managers get special services for paying inflated trading costs to outside brokerage firms. The problem is that the investors, you and me, are the ones forking out the dough for these extra fees. These costs are unreported and nearly impossible to quantify, but a study by Stephen M. Horan suggested that U.S. soft dollar brokerage commissions could total $1 billion annually, or up to 40% of all equity trading costs.

5. Cash Drag. In order to maintain liquidity for potential transactions and redemptions, mutual fund managers hold cash positions, which don’t generate any interest. We are paying an expense ratio on 100% of our money invested even though not 100% of our money is actively working for us. According to a study by William O’Rielly and Michael Preisano, the average cost from cash drag on large cap stock mutual funds over a 10-year time horizon was 0.83% per year.

6. Advisory Fees. This fee is only relevant to those who work with a fee-based financial or investment advisor who selects mutual funds for their clients. Many fee-based advisors charge 0.25% to 2.5% of the portfolio’s balance. This fee is disclosed but it is in addition to all of the other charges on this list and it definitely takes its toll on our finances.

7. Redemption Fees. Investors who want to sell their fund position may pay a redemption fee. The Securities and Exchange Commission (SEC) has limited the fee to 2%, which is still expensive since you shouldn’t be paying anything in the first place.

8. Exchange Fees. Some funds charge investors who move from one fund to another within the same family of funds (funds marketed under the same brand name).

9. Account Fees. This is the price some funds charge just to have an account open.

10. Purchase Fees. This is a charge to purchase a fund that goes directly to the fund company.

11. Front-End Load Or Back-End Load Fees. This charge is essentially a commission you pay when you buy (front-end load) or when you sell (back-end load) the fund. Loads cut into profits and there’s no evidence they produce better results than no-load funds.

A big thanks to Tony Robbins, and his book Money: Master the Game, which I highly recommend, for bringing most of these fees to light for the average investor.

Fees Matter

That list of fees is exhausting isn’t it? But it’s important and I’ll show you why. Here’s a quick summary of the harshest fees that can be quantified:

 

“The Real Cost of Owning a Mutual Fund,” Forbes

 

You’ll notice that this table uses the lower end of the expense range for the different fees. In other words, the 4.17% total cost of a taxable account may be closer to 5% plus the 7 other fees we discussed above. So in reality, this table likely understates what we’re actually paying when we invest using actively managed funds.

It’s like paying closer to $50 for every $1,000 we have invested when we should be paying under $10. A $40 difference may not seem like a big deal but it is, especially over the long haul.

Let’s look at an example from a previous post to illustrate the point.

Four friends, Matthew, Mark, Luke, and John had $100,000 each to invest. All of them generated the exact same 7% per year return for 30 years, but they all had different fees.

  • Matthew invested in a taxable account that had average fees of 4.17% per year
  • Mark invested in a tax advantaged account that had average fees of 3.17% per year
  • Luke invested in tax advantaged funds that only charged an average 2% per year
  • John invested using index funds that that cost an average of 0.5% per year

Let’s see how each of the friends fared after 30 years:

  • Mathew: $230,991
  • Mark: $308,806
  • Luke: $432,194
  • John: $661,437

These friends invested the same amount, for the same time, generating the same pre-fee returns, but John was able to amass more than $400,000 or nearly three times as much as Mathew. There is no such thing as “low fees” when it comes to investing! FEES MATTER!

This depiction may be more telling:

 

 

Even though this is just an example, it’s a reality all of us face. You may be like Matthew or Mark and invested in actively managed funds that promise strong growth, but your fees won’t allow you to be the beneficiary.

Maybe you’ve wondered why your portfolio seems to stay flat despite the fact the stock market has averaged about a 13% return per year since 2010.

If in 2010 you had $100,000 invested in an S&P 500 index you should have $200,000 today. If you had a million in 2010, you should have 2 million today. The S&P 500 and the total stock market have more than doubled since the beginning of 2010.

If your invested money hasn’t nearly doubled since 2010, then you’re invested in high-fee funds that are stripping you of your money.

Investing is not enough. We must do so wisely. Keeping investment fees low is one of the best ways to amplify our financial success and boost our financial freedom.

Beat the Dirty Little Secret

Alright, so we’ve discovered that actively managed mutual funds strip us of thousands of dollars, and fund companies don’t disclose all of the fees we have to pay.

So what’s our best option?

In order to amplify our investing success we must achieve three objectives:

  1. Keep Fees Low
  2. Generate Strong Returns
  3. Reduce Risk

When it comes to investing in the market, these three objectives are generally best achieved over the long term by investing using index funds.

Nearly all of my money I hold in the market is invested in multiple index funds. Here’s how my portfolio aligns with the three primary investment objectives:

1. My investment fees are minimal. My highest expense ratio is 0.16%, which is 84% lower than the average expense ratio of funds with similar holdings. Index funds have low turnover, so my transaction costs are well below most other funds. Most of the 11 fees detailed above (loads, advisory fees, redemption fees, soft-dollar costs, etc.) don’t apply to the funds I own due to the brokerage I use and funds I’ve selected.

2. My returns are strong. My market investments have generated over a 13% return (after fees) per year since inception. This is a much stronger track record than most actively managed funds can claim.  

3. My index funds are well diversified minimizing my risk. For the most part, my risk is spread over 500 of the largest, most successful companies. There’s a possibility that the stock prices for all of these companies could plummet at the same time, but that risk is far less than any individual company’s stock tanking.

For more detail on how to invest using index funds read The Best Way To Invest In the Market. It provides all the details you’ll need to buy index funds including what to look for in a brokerage company and how to know which fund to buy.

Conclusion

There you have it. Now that you know all the fees and just how much they’re costing you, you can beat mutual funds’ dirty little secret.

Buy inexpensive, strong performing, well diversified index funds, and you’ll be a better investor than most of the so called pros.

Action Steps

Look at your current investments and see if they are actively managed funds or index funds. This includes your investments in your 401(k). If there actively managed, stop contributing and open an account with a brokerage firm (Vanguard, Fidelity, Charles Schwab) and start contributing to index funds.

See The Best Way To Invest In the Market for more details about how to actually do it.

See The Ultimate Step-By-Step Guide To Making the Most of Your 401(k) to know exactly what to do with your 401(k) investments.

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Please comment! Please let me know what you think—what you liked, what you didn’t, any questions you have, or future topics you would like to see discussed. I want this to be about YOUR financial freedom! I want to provide answers to what YOU need help with!

Photo Credit: Craig Sunter

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