All mutual funds, bond funds,
and other investments have expenses. If you
buy a stock, you must pay a commission. If
you buy a mutual fund, made up of stocks
or bonds, you pay a management fee, plus
commissions and transaction fees based on
how often investments within the fund are
traded. Many funds also charge so-called
12b-1 fees for marketing, which by law are
capped at 1%. For stock funds, management
fees average 1.5%, while commissions and
transaction fees average 1.6%. So, in total,
the average fee subtracted from your account,
if you own a stock-based fund is 3%. For
a full list of investment-related expenses, click
here. Add
on top of that 401(k) administrative
fees, which are routinely deducted from
investment returns, and participants
in many 401(k) plans, especially smaller
ones with less than $3 million in combined
assets, may be paying upwards of 4%
every year to invest their own money.
Compounded
over time, this 4% can mean the difference
between a comfortable retirement and
living hand-to-mouth.
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Try to Beat the Market While Paying 4%; You Might As Well Search
For a Needle in a Haystack.
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Many fund managers argue that expenses are only a minor factor to
consider, and performance is a much more important factor in
generating wealth.
Well, the problem with this is that while expenses usually stay
about the same for a fund year in and year out, performance does
not. And
there is no way to accurately predict which funds will outperform
the market.
Statistically,
there is no correlation between higher
expenses and higher market returns. In
fact, the opposite is true. "There's
definitely a correlation between lower
fees and performance," explains
Morningstar mutual fund analyst Laura
Pavlenko Lutton. "High fees eat
into your returns year after year."1 To
see for yourself, click
here.
By
definition, ½ of
all funds will outperform the market
average every year. The other ½ will
do worse than average. The following
year another ½ will outperform
the average, while the other ½ will
underperform. Guessing which funds
will be in the top half year in and
year out
is tricky business, especially when
you consider that out of approximately
16,250
mutual funds on the market, based on
the laws of averages, excluding fees,
only 508 will out perform the market
average each year for 5 years in a
row. Including fees, the actual number
of
mutual funds that outperformed the
market average five years in a row
is 177.2
The odds
of finding those top-performing funds
are less than 1 in 93. (This is about
the same odds as catching a foul ball
in a major league ballpark if you go
to six baseball games during your lifetime).
So unless you’re feeling lucky… |
A
Beach Lesson
Imagine
you are in a race to build a
sand castle. To build your castle,
you must choose between buckets
of sand, resting on a high wall
over your head. You can’t
see how much sand is in each
bucket. However, examining each
bucket you notice that each has
a hole near the bottom. Some
holes are small, and some are
big. Which bucket would you pick?
Unless
you are really lucky, the greater
the size of the hole, the longer
you have to wait to complete
your castle.
Investors
face the same challenge. Some
investments will perform well,
and some will perform poorly.
Investors don’t know ahead
of time which investments will
be stars and which will be laggards.
However, based on history, investors
can accurately predict expenses.
Expenses
are the holes in their investment
bucket, and expenses are the
most important determinant in
deciding how long investors must
wait to until they can complete
their retirement castle.
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Consider
the impact of reducing fees by only 3%
on an individual 401(k) account, where
an employee contributes $8,000 a year.
• In
15 years, the employee would have saved
$64,096.
• In 20 years, the employee would have saved $146,004.
• In 30 years, the employee would have saved $538,711.3
This is
why the primary responsibility of all
prudent investors and those overseeing
other people’s 401(k) accounts
should be to minimize fees. By doing
anything less, you might as well bury
your head in the sand.
You can
read additional articles on the challenges
of “beating the market” and
the importance of fee control in our library.
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1 Joshi
Pradnya, "Hidden Fees Concern
Mutual-Fund Experts, Consumer Advocates," Newsday,
Knight Ridder/Tribune Business News, March
7, 2004.
2 Source:
Morningstar, annualized returns for all
mutual funds, 1999-2003, based on standard
reporting convention, after management
and administrative fees have been removed,
excluding loads, trading commissions and
other transaction expense. 3 Assuming
an employer annual match of $3,500 and
market appreciation of 8 percent each year.
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