The True Cost of Investment Fees

One of the best ways to maximize the returns of your portfolio over the long term is to minimize investment fees.  The impact over time of these fees is much greater than many realize.  For example, a $500,000 portfolio with an average fund fee of 1% equates to $5,000 per year which compounded over forty years would ultimately cost almost $800,000 (assuming a 6% portfolio return and a 3% withdrawal rate in retirement). 
 
To make matters worse, many clients use advisors who charge a 1% fee and then invest the client’s assets in mutual funds that also charge a 1% fee.  This 2% fee would ultimately cost $1.4 million over forty years again assuming a $500,000 portfolio, a 6% portfolio return and a 3% withdrawal rate.  The only way these fees can be justified (from a pure portfolio perspective) is if the advisors and fund managers are able to earn a portfolio return greater than the cost of the fees.  The evidence suggests that this is not likely to occur.
 
A study by Vanguard found that of all the actively managed mutual funds that existed in 1988 only 18% were able to beat their respective indexes by enough to justify their fees over the next fifteen years.  And all the funds that did achieve this had several years of relative underperformance.  It is extremely difficult to consistently beat the market through stock selection and virtually impossible for an individual investor (or a financial advisor) to figure out ahead of time which fund managers will be the ones to accomplish that relatively rare feat.
 
Other studies including a recent one by Morningstar commissioned by the New York Times have shown that the only variable that can consistently be used to predict outperforming funds is low fees.  They did not find any correlation between past fund performance, manager tenure or any other variable that predicted future outperformance.
 
The real value added work in portfolio construction is determining the optimal asset allocation (stocks/bonds/real estate etc.).  This allocation will be a function of your time horizon, risk tolerance, income needs during retirement and level of social security and other pension income.  Good financial advisors will have sophisticated planning software that will allow you to plan out your retirement cash flow.  Many of these software packages provide Monte Carlo analysis (which run thousands of iterations of possible outcomes) to help determine the asset allocation that maximizes the probability of meeting your goals no matter what the sequence of market returns.  Invest too conservatively and you will not keep pace with inflation.  Invest too aggressively and you run the risk of a significant market correction (e.g. 2008) causing your portfolio to take too great a hit to be able to recover.

Once an asset allocation is determined, deciding on the securities to purchase is relatively simple.  Just use low cost broad based index funds. The fees for these funds range from 0.05% to 0.20% which is significantly lower than the fees on actively managed funds.  In addition, these funds are more tax efficient which helps to lower the tax bill for funds held in taxable accounts.
 
The key to building your retirement portfolio is taking a slow but steady approach.  Work with an advisor on getting the asset allocation right, use low cost index funds to keep fees low and rebalance your portfolio/update your financial plan once a year (a topic for another blog post).