They say you have to spend money to make money. But the money you pay to invest has a big impact on what you have left in your own pocket. Every investment has a cost, even if you don't realize you're paying it. There are many different kinds of costs, but they all have one thing in common: If the money is going somewhere else, it's not going to you.
Why do costs matter?
Investment costs might not seem like a big deal, but they add up, compounding along with your investment returns. In other words, you don't just lose the tiny amount of fees you pay—you also lose all the growth which that money may have made for years into the future. Let’s take an example:
Imagine you have USD 100,000 invested. If the account earned 6% a year for the next 25 years and had no costs or fees, you'd end up with approx. USD 430,000. If, on the other hand, you paid 2% a year in total costs, after 25 years you'd only have about USD 260,000. So you can see how the 2% you paid every year would wipe out almost 40% of your final portfolio value. You can now see the significance of the leverage that additional costs and fees make.
What types of fees are there?
Fees typically come in two types—transaction fees and ongoing fees. Transaction fees are charged each time you enter into a transaction, for example, when you buy a stock or a mutual fund. The situation differs in the case of managed portfolios as these usually do not require any up-front payment. In contrast, ongoing fees or expenses are charges which you will incur regularly, such as a management fee and they are usually paid on a monthly basis.
The most commonly used gauge of the total fund costs or Exchange Traded Funds costs is the expense ratio. The expense ratio measures operating expenses relative to the total value of the fund. Operating expenses consist of the fund management fee, marketing costs, custodial services, recordkeeping, taxes, legal expenses, accounting fees, etc. Shareholders pay these operating expenses on a daily basis through an automatic reduction in the price of the fund, without even sending you any information about the fact. The most reliable source of information about all type of costs which are passed on to clients is the prospectus or KID (Key Information Document).
What can you do to control your costs?
Because all investments have costs, it might seem like a waste of time to worry about them. Or maybe you assume that a higher price means higher quality. But that’s not true!
Research on mutual funds has shown that the higher-cost funds generally underperform lower-cost funds. That's because the fund managers who are charging these costs have a difficult time adding enough value to overcome the additional expenses.
According to Morningstar’s 2015 Fee Study, asset-weighted expense ratios across all mutual funds and exchange-traded products have fallen from 0.76% in 2009 to 0.64% in 2014. This asset-weighted measure reflects what investors are paying in aggregate, whereas a simple average of all funds in 2014 was 1.19%. The Morningstar study points out that just 9% of the total investor assets at the end of 2014 were placed in funds paying greater than 1.19%. So if you are wondering if you are paying too much for your investment funds, let this serve as a simple baseline for it being a fund that is too costly.
The bottom line?
There are certainly some things you shouldn't bother worrying about when it comes to investing. But costs are one of the driving factors that dictate whether you'll reach your goal—and they're one of the only factors completely within your control. So, give them the time and attention they deserve!
To see our key information about investment funds, please visit KIID page.