“No one thinks too much about fees,” says Kylelane Purcel, a fund expert with Morningstar, Inc.
“High fees are a yearly drain on investments. Look at the Vanguard group of bond funds, for example. They inevitably rank high in their categories, and it's not that they have an exceptionally risky strategy — they just keep their expenses low.”
A Major Bite
Are expenses really that important? Yes! You invest $1,000 a year in a growth fund that charges you a 4.5 percent sales charge and charges annual expenses equal to 1.5 percent of your assets in the fund. If you hold the fund for one year, it will need to return 6.4 percent just to break even. And even if you hold it for five years, the fund must return more than two percent annually just to get you above water. By contrast, a fund with no initial sales charge and a low 0.7 percent annual expense ratio will need to return only 0.7 percent each year to bring you to a point where you can start earning profits.
Look at it another way: If you invest $2,000 (before expenses) in the fund with the 4.5 percent initial sales charge and the 1.5 percent expense ratio you will accumulate about $9,700 during the next 20 years, assuming the fund's investments generate a 10 percent annual return before expenses. If you instead choose a no-load fund with a similar annual return and a reasonable 1.0 percent expense ratio you’ll amass more than $11,200. That’s an extra $1,500 on an investment of $2,000!
Reducing Risk
For decades, academic researchers have struggled with the issue of whether it is possible to increase your investment returns without taking on additional risk. Well, we just settled the question: All you have to do is seek out funds with low expenses.
What should you do? If you’re happy with the performance of the funds you own, then don’t worry too much about expenses. For one thing, if you’ve already paid a front-end sales charge it’s too late to get that back. But if you’re not satisfied with the performance of one or more funds in your portfolio, you should check their fees; they might provide another reason to unload those funds.
Hidden Expenses
In fact, it may be difficult to keep track of all the fees a fund or its sponsor charges. The most important ones include sales charges, which range from zero on “no-load” funds to 4.5% or even higher. The fees generally help reimburse the brokers who sell the funds, so if you want to buy funds through a broker you may have to pay a sales charge. But if you’re willing to follow your own advice, you can buy no-loads simply by calling their sponsors and asking for a prospectus and application.
Some funds also charge a back-end load on sales of shares that have been held for less than a specified period, typically around one year. In other cases, the fees decline gradually over time and peter out after two or three years.
Both load and no-load funds carry annual fees that are summed up in their “expense ratios”, which you can check in their prospectuses. Those fees typically range from 0.15% to 3%, and over time they are more significant than you might think. A study by the Morningstar Five-Star Investor in Chicago found that a $10,000 investment growing 10% per year would produce almost $10,000 in profits over ten years. But a 1% expense ratio reduced those returns by almost $2,000. If you are saving more significant amounts–as in a retirement account or college savings fund–fees could end up costing you far more over the years.
Of course, low fees are little help if you don't choose funds that can deliver solid investment returns. Thus, you should pay careful attention to a fund’s performance over time, as well as its risk. That done, however, you should also check out its expenses. That might take a few minutes, but the return on that investment of time could equal thousands of dollars in the long run.
