Investment Costs Matter

“Costs matter. A lot.”

When I was a student at Brigham Young University, I did a study abroad in the Middle East. Most of our time was spent in Israel, Jerusalem in particular, but we also travelled to Jordan and Egypt.

One of my favorite experiences in Egypt was going to the Bazaar.

This was an outdoor market where merchants set up shop to sell their products. Our guide gave us some advice: No matter what the vendor asks as their starting price, always begin your offer with one dollar. 

So off we went, a bunch of Americans at an Egyptian bazaar trying to buy scarves, trinkets, and other goods with our limited negotiation skills.

I didn’t have a watch, so I was interested in buying one. There was a gentleman selling them and I asked him about the cost. He quoted some absurdly high price, I don’t recall what the amount was. So I took my guide’s advice and offered $1. A look of horror and offense came across his face. There was no way he was going to sell his watch for such a ridiculously low price. 

The whole experience turned out to be a lot of fun. Back and forth we went and I think that I eventually purchased the watch for $5 or $10. I was so happy with the experience that I took a picture with the watch seller. And to be honest, I thought I’d gotten quite the deal.

Of course, later that day the watch stopped working. 

So even though I got a bit swindled, it was only $5-$10 bucks—no big deal. 

The problem is that investors, often very intelligent people, may be paying fees that they don’t even know exist in their mutual fund and ETF holdings. Many times there are alternative funds that provide a similar allocation, but for a fraction of the price.

Why would an investor not be aware of an investment fee? This is likely because you don’t typically write a check to pay investment expenses. Because you don’t feel the pain of pulling out your wallet, or handing over the cash, you don’t make a stink about it. But even though you go on your way, those costs are adding up, and you are still paying them!

The late great, John C. Bogle had a lot to say about investment expenses. All of the quotes in this article are taken from his 10th anniversary edition of The Little Book of Common Sense Investing

Here are a few quotes to get us started:

  • “We investors as a group get precisely what we don’t pay for. If we pay nothing, we get everything.” (42)

  • Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy.” (47)

  • “Costs make the difference between investment success and investment failure.” (49)

  • “Fund performance comes and goes. Costs go on forever.” (54)

  • “Costs matter. A lot.”(57)

Fund costs.

I’m a fan of mutual funds and ETFs, and in my estimation, more and more investors are leaving individual stock-picking behind in order to benefit from a well-diversified portfolio of funds. There are costs, of course, with maintaining a fund and offering the product to consumers. I don’t think reasonable people have a problem with reasonable fees. The problem is that many mutual fund and ETF fees are too high, or simply unnecessary.

Sales Load (Charge)

When you purchase a mutual fund, you may be charged a sales load. This is a commission that is paid to the seller of the product. My experience has been that this sales load is often somewhere around 5.75% for front-end fees. 

But what does this mean?

Say that you want to deploy $10,000 into the market. So you call your brother-in-law, who you know just started a career with HighCost Advisors, LLC. You tell him what you’re looking for, and he says he has the perfect thing. A mutual fund. He shows you the reports, etc, etc and you buy in. You write the check and of your $10,000 investment, $575 (5.75%) of it is given to your brother-in-law as a commission.

You scratch your head and think, “Well that’s just the cost of doing business.”

The problem with this thinking is that it’s simply not true. There are plenty of mutual funds out there without sales loads. So because you don’t need to pay them, you simply shouldn’t. 

Don’t purchase funds with sales loads.

Expense Ratio

Each mutual fund and ETF has an expense ratio. This percentage proves to be incredibly important.

Again, reasonable people don’t mind paying reasonable fees. They recognize that there are people that run the fund that should get paid for their work. At issue here is the question: What are reasonable fees?

The answer hinges on whether you believe it makes sense to pay for active management of your mutual fund, or whether you believe a passive index fund strategy is most appropriate. In my opinion, the vast majority of investors should completely, or principally, invest in passive index funds for their market holdings.

Again, from John C. Bogle: “During the past 25 years: average net annual return of lowest-cost funds, 9.4 percent; net annual return of highest-cost funds, just 8.3%, an enhancement in returns achieved simply by minimizing costs.” (emphasis mine, 57)

Because you don’t have to pay high expense ratios to own great mutual fund and ETF securities, you shouldn’t. The fund expense ratio is often overlooked by investors. You should look at yours to see what you’re paying.

Don’t purchase funds with unreasonably high expense ratios.

Transaction Costs

In many cases, there will be transaction costs on the purchase and sale of a security. Meaning that any time you decide to sell, or to buy, there will be costs associated with those maneuverings. There are some companies, such as TD Ameritrade and Vanguard, that are offering commission-free ETFs, or transaction-free mutual funds. While I don’t believe free transaction costs are the most important determinant in fund selection, I do believe that they are an important factor.

Funds with high turnover will necessarily have higher transaction costs—there’s a lot of buying and selling going on. 

From The Little Book of Common Sense Investing, Bogle writes, “We estimate that turnover costs are roughly 0.5 percent on each purchase and each sale, meaning that a fund with 100 percent portfolio turnover would carry a cost to shareholders of about 1 percent of assets, year after year.” (55)

Another case for why an index fund approach makes sense . . . there’s simply less turnover.

Taxes

Fund turnover also impacts taxes. When a fund manager does a lot of buying and selling, those actions may trigger taxable events. For securities that are held for less than a year, gains are treated as short-term capital gains—taxable at ordinary income tax rates, instead of at the more favorable 0%, 15% or 20% tax rate for long-term capital gains. 

An index fund tracks an index, such as the S&P 500 and does not actively attempt to beat the market. There is great wisdom in humbly accepting what the market provides and not greedily attempting to beat it. 

Attempting to beat the market may lead to unnecessary costs and lower returns.

Bogle writes, “The average actively managed equity fund earned an annual after-tax return of 6.6 percent, compared to 8.6 percent for the index investor. Compounded, an initial 1991 investment of $10,000 generated a profit of $39,700 after taxes for the active funds, less than 60% of the $68,300 of accumulated growth in the index fund. The active lag: a loss to their investors of some $28,600.”(89)

Don’t purchase funds with unreasonably high turnover.

Some final thoughts.

As we’ve discussed, costs matter. 

If you’re beginning to invest, or have been for some time, consider blocking off a few hours this weekend to review the investments that you’re currently holding across your accounts. 

If you find you’re paying too much for the investments, develop a strategy for shifting your assets to more cost-effective funds. Be careful to take tax considerations into account when doing this in taxable brokerage accounts.

If you’re working with a financial advisor and you find they are utilizing expensive funds, you should set up a conversation to determine why those funds are being used. Your advisor will likely have a reason, but you should determine whether or not that reason is sufficient for the higher price that you’re paying when so many low-cost, highly efficient, funds are available. (And if you aren’t sure your current advisor has your best interests in mind, I’m sure you could fund a few other advisors who would be willing to give you a second opinion.)

If you find that you don’t have time, or would rather a professional review your portfolio, seek out a fee-only financial advisor who you can pay on an hourly (for projects) or flat retainer (for ongoing planning and investment management) basis.

Disclaimer:

The content you just read is for informational purposes only. Yes, I’m a financial advisor, but this article really isn’t intended as advice for you specifically. Your unique situation needs to be taken into account, and the ideas presented here may not apply. 

So, please make sure you do your due diligence BEFORE implementing anything. Due diligence includes hiring a qualified professional who understands your situation completely and can offer you personalized advice.

Donovan Sanchez