One of the most common mistakes I see investors make is failing to understand the true cost of investment fees. Many investors dismiss an annual management fee of 1 percent as “just” 1 percent.
Just as investment returns compound over time, so does the impact of investment fees. Over a twenty year period, a fee of “just” 1 percent reduces an investor’s end return by approximately 17 percent. Throw in an advisor’s usual annual advisory fee of 1 percent and an investor has reduced their end return by 34 percent. If an advisor persuaded an investor to purchase a variable annuity, with annual fees of 2 percent or more being the norm, the cumulative fees of 4 percent would reduce an investor’s end return by 68 percent!
Fees for actively managed mutual funds are typically much higher than the stated annual management fee. This is especially true for so-called “closet index” funds. Closet index mutual funds are actively managed mutual funds that closely track a relevant market index.
Closet index funds are actively managed mutual funds that have a high R-squared rating. A fund’s R-squared rating indicates the percentage of an actively managed mutual fund’s performance that can be explained by a relevant market index. An R-squared rating of 90% would indicate that 90% of the fund’s performance could be attributed to the performance of the market index rather than the fund’s active management.
Professor Russ Miller has developed a metric, the Active Expense Ratio, that uses a fund’s R-squared rating to help investors determine the effective fees that investors pay on actively managed mutual funds. His findings are that investors investing in actively managed mutual funds are usually paying effective annual management fees that are four or more times the fund’s stated annual fee.
A final approach to evaluating the true cost of actively managed mutual funds is based on the incremental cost and incremental return of an actively managed mutual funds. This concept was first introduced by Charles Ellis in “Winning the Loser’s Game,” which I consider to be one of the most helpful book for investors. My proprietary metric, the Active Management Value Ratio, used incremental cost and return, as it more accurately reflects the added cost and added benefit, if any, resulting from active management.
Let’s assume that an actively managed mutual fund has an annual return of 22 percent and an annual expense fee of 1 percent. A comparable index mutual fund has an annual return of 20 percent and an annual expense fee of 0.22 percent. The incremental return of the actively managed mutual fund would be 2 percent, or 200 basis points, and the incremental fee would be 0.78 basis, or 78 basis points. (A basis points equals 0.01 percent, so 100 basis points equals.)
Since the public may have trouble understanding the concept of basis points, I like to present an analogy using dollars instead of basis points. One of the keys to successful investing is to avoid unnecessary fees, as fees effectively reduce an investor’s end return. So which option is better for investors, paying $22 for 20 percent return or paying $78 for 2 percent return? Yet another cost efficiency way of looking at the options would be which option an investor considers more prudent – paying $22 dollars for 20 percent annual return , or $100 dollars for 22 percent annual return.
The answer seems obvious, and yet the Investment Company Institute reports that over 80 percent of money invested in mutual funds is invested in actively managed funds, with a large percentage of the investment coming from pension plans.
Costs do matter.