Just imagine, retiring 5 years earlier than planned, simply by switching from mutual funds to exchange traded funds. The difference between retiring in 30 years, instead of in 25 years, can be all just due to mutual fund management (MER) fees. How is that possible? Aren’t mutual fund fees something tiny like 1 or 2%?
Mutual fund fees need to be compared against the benchmark expected return
Mutual fund fees are always quoted based on the amount of money you have invested in the fund, not on the amount of money you are making from owning the fund.
The way mutual fund fees are presented is a bit like dividing maintenance fees on an investment condo by the full price of the condo. It’s a great way to make those fees look small, but not a very accurate way of measuring their true cost. If we want to assess whether the condo is a good investment, we would instead check how those fees compare to the rent charged to tenants.
Similarly, we need to compare the fees mutual funds charge to the investment returns they are likely to provide.
How much does an average mutual fund tracking the S&P 500 really charge in fees?
Let’s say we invest $10,000 in a mutual fund tracking the S&P 500 and charging a 2.11% management fee. This type of fund, if it does it’s job well, should return approx. 10% per year over the long term with dividends reinvested (before fees).
Therefore, in an average year we will pay 2.11% out of the 10% annual return or 21.1% of our expected return in fees.
In dollar terms, that’s a potential return of $1,000 on the year being reduced by $211 to earn us only $789. That’s a huge difference!
What about the lower fee bond funds?
The news does not get better with lower fee funds because they also generally offer lower expected returns. For example this bond fund charges only a 1.47% fee, which might seem like a bargain compared to the one above, however the fund is also only expected to return 5.2%.
This means the fund fee is actually 1.47% out of 5.2% yearly return, or 28% of our expected return in fees.
In dollar terms, that’s a potential return of $520 on the year being reduced by $147 to earn you only $373. Despite this fund charging a lower fee on your investment, it’s actually more expensive than the S&P 500 fund when compared to it’s expected return!
How about over the long term?
I hope you can see, from the two examples above, that mutual fund management fees are actually far bigger than they first appear. The problem just gets worse over time though because of compounding.
Assuming a 10% annual return on the S&P500, here is a 3 year comparison between the mutual fund charging 2.11%, and a comparable exchange traded fund charging a 0.17% fee.
Per $10,000 invested
|End of||End of Year Balance 0.17% fee||End of Year Balance 2.11% fee||Additional fees paid for 2.11% mutual fund over 0.17% ETF|
We can see that the total of additional fees paid after 3 years, is greater than 3 times the 1 year additional fee ($689.72 > 3 * $194). Why? The fee reduced balance after each subsequent year is smaller, which in turn means the same 10% return generates less money. This effect is called compounding and it greatly amplifies small differences over long periods of time.
After 25 years, assuming a 10% annualized return, a $100,000 mutual fund investment (2.11% fee) will turn into $667,621. That’s not bad, but the same $100,000 will be worth $1,042,376 if invested into the 0.17% exchange traded fund.
That “little” 2.11% fee ends up costing us around $330,000, or 30% of our total potential retirement nest egg!
Incidentally, it takes an extra 5 years before the mutual fund balance comes close ($975,969) to that of the exchange traded fund.
What would you do with an extra 5 years of retirement?
Note sure where to start? See my article on how to set up an exchange traded fund (ETF) based retirement portfolio in 3 easy steps.
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