As the old adage goes, “You get what you pay for.” In many respects, the same holds true for the investment industry.
Understanding how fees work can seem daunting and the investment industry can appear complicated which is intimidating for many investors. As a result, it’s common for investors to make rash choices when navigating fees by sticking to the “cheaper is better” mindset. We want to help investors go beyond reactionary thinking and make better financial decisions.
Understanding Expense Ratios
The fees that most investors hear about in the news these days are those associated with mutual funds and exchange traded funds (ETFs). Commonly referred to as expense ratios, these fees are stated in terms of a percentage amount of the total funds invested. For example, it would cost a person who has a $100 investment in a mutual fund with an expense ratio of one percent about $1 each year to invest in that mutual fund. In practice, it’s not that simple because investments fluctuate in value. Because of that, it’s easier for investors to think about the cost of an expense ratio in terms of annual investment return. For example, if that same mutual fund with a one percent expense ratio has an annual return of eight percent, the net of fee return to the investor will be about seven percent.
How does an investment company determine what a particular fund’s expense ratio should be? Generally this depends on how expensive it is for that company to operate that fund. Actively managed funds require a team of portfolio managers and analysts, as well as various resources for investment research. On the other end of the spectrum, passively managed funds that aim to mimic an index do not have the operational cost of portfolio managers, analysts and research related resources. This is why passively managed funds tend to have lower expense ratios than actively managed funds.
How do Most Investors Think about Fees?
The hot investment trend today is to go out and find the lowest cost investment available. After all, plenty of actively managed funds don’t even beat the index that they’re paid to outperform, so why should an investor pay more to invest in one? This is a fair point, but far too often investment fees are the only thing investors consider when making decisions, and they frequently sacrifice better returns because of it.
In the consumer-centric world that we live in, fees should be a part of any decision making process. The investment industry is different from most, though. When you buy a luxury car, you’re making a deliberate choice to have less money in return for a nicer car. It’s a tradeoff. In the investment industry there’s a different dynamic in which paying more may actually lead to greater wealth in the long run. It all depends on an investment’s performance net of fees.
Net of Fee Returns—The True Measure of Performance
When all is said and done, the number that investors need to pay more attention to than fees is a fund’s net of fee return. Think about it: if the actively managed fund has a higher return after accounting for its expense ratio, isn’t that the better option? In fact, looking at a fund’s net of fee return will actually be a better indicator of whether a fund is too expensive than by just looking at an expense ratio. This is because the higher the expense ratio, the higher the hurdle that active manager must surpass to offer returns superior to the fund’s benchmark index.
Net of fee returns aren’t the end of the story, either. One of main advantages of an actively managed fund is that the fund manager has the ability to intentionally take on less risk than the fund’s benchmark. For many investors, particularly those who are risk averse, getting a smoother ride in a particular fund compared to the index is worth paying a higher expense ratio.
Your Next Step
This doesn’t mean that the answer is to go pick any actively managed fund, either. The truth is that the industry has plenty of active managers who cannot beat their benchmarks. That said, many do beat their benchmarks over the long term (and if you’re investing for retirement, for example, chances are you’re investing for the long term.) Shunning all actively managed funds because many don’t do a good job and charge higher fees is like skipping the doctor and trying to diagnose your symptoms with WebMD instead. Investors just need to take care that they thoroughly research their investment options before choosing any, or that they work with an experienced advisor who knows what to look for.
At ACG, investment fees are an important factor in weighing investment decisions for our clients. But it’s not the only factor. Our goal is to help clients find investments that offer superior returns on a net of fee basis. If you’d like to learn more, we’re always ready for the conversation. Contact us today!