Let’s put aside our rosy glasses, put on our fine print glasses and look at some percentages regarding investment fees.
I will compare two bond funds holding the same type of bonds. Fund A, an index fund, charges .5% while Fund B, an actively managed fund, charges 1.5% in management and other expenses. The manager or salesperson for Fund B may tell a prospective client that the returns for their fund are superior and will make up for the 1% difference in fees. Many brokers are of the Lake Wobegon mentality, believing that the products they sell are above average.
1% sounds like a small amount so this might seem reasonable to you if you are wearing your rosy glasses. But let’s look at some hard data. Let’s say that the index Fund A averages a 5% return before expenses. The more actively managed fund B would have to earn 6% before fees just to break even with the return on Fund A. Again, that 1% sounds small but what it means is that Fund B has to make a return that is 20% greater than the index. Very few funds are able to do that.
Let’s look at those fees again as a percentage of the return, not the total dollars invested. On a 5% return, index Fund A’s fee of .5% is 10% of the return. Even if Fund B can generate a 6% return, it’s 1.5% fee is a fat 25% of the return, more than what many hedge funds charge.
Let’s say that Fund B has generated these higher returns in the past. How does it do that? Often, by taking more risk than the index fund A. You can check an assessment of a fund’s return vs. risk at any number of stock research sites. Yahoo’s finance site has some good assessment tools. Enter the fund’s symbol and in the resulting summary page, click on “Risk” in the left column. You will be taken to a page which shows 3 year, 5 year and 10 year risk and return ratios.
Alpha measures the amount of return for the degree of risk involved. The average is 0. Less than 0 means that the fund does not get a return commensurate with the risks it takes. More than 0 means that the fund gets a better than average return for the risks it takes. You will be able to compare the fund with other funds in its category.
There are so many index funds and low cost index ETFs in the market for an investor to choose from. If you are willing to take more risk in bonds, for example, you can probably find an index product that invests in a riskier class of bonds. Over the long run, expense fees do matter. The lower the return, the more they matter. Over 10 years, that additional 1% in fees will cost you $1400 on a $10,000 investment in a fund averaging a 5% return.
In short, play the percentages.