An Easy Way to Boost Returns: Reduce Your Costs

Every dollar you do not spend on expenses is a dollar you get to keep and grow. It’s basic math and an easy way to boost your returns. Each dollar spent on expenses flows out of your portfolio, never to be seen again. Limiting the outflow of those dollars gives you a larger amount of capital to grow and/or earn income on.

The key to this equation is compounding. I realize many of you are familiar with the concept, but since not everybody is—and since AAII’s mission is to educate investors on how to be better stewards of their portfolios—I’m going to give a brief example: A half of a percentage point (0.5%) reduction in expenses on a $1 million portfolio results in $5,000 in savings. A modest 5% rate of return turns the initial $5,000 into nearly $6,400 over a period of five years.

Sounds pretty good, right? But the initial savings is just the tip of the iceberg. Each year the portfolio increases in value (to keep things simple, I’ll treat the portfolio as solely being investing in funds), the benefit from the savings rises as well (assuming you maintain the 0.5% reduction in expenses every year going forward). This because the expense is based on the total amount of your portfolio. As your portfolio grows in value, so do the total dollars paid. The end result is not merely $25,000 in additional wealth (five years of saving $5,000 in expenses), but rather more than $32,000. The compounding of savings is why many encourage investors to focus on reducing costs. There is a direct and significant benefit to keeping costs as low as is logical to do so.

To lower expenses, you have to know what they are. Some costs are very apparent. Every time you buy or sell a stock, your broker immediately charges you a commission. Some expenses are more opaque. Bonds, for example, are often quoted with the commission baked into the price the broker says they can execute the trade at. Others costs require even more awareness on the part of the investor.

Alternative funds, for instance, can be much more expensive than many investors realize. An article this week in Investment News used TFS Market Neutral (TFSMX), and two other “alt” funds to make this point. TFS Market Neutral fund seeks to provide capital gains, while maintaining a low correlation to the S&P 500 and staying less volatile by both investing in and shorting various securities. Our mutual fund guide, which uses data supplied by Morningstar, lists the fund’s expense ratio as 1.89%. The fund’s website, however, lists an expense ratio of 8.40%.

The wide difference reflects the transaction costs incurred by the fund. TFS Market Neutral has a turnover ratio of 669%, which implies a massive amount of buying and selling. In addition, the fund incurs borrowing costs from shorting securities. These costs are not embedded in the management expense ratio of operating the fund, but are costs nonetheless. When Vanguard’s Jack Bogle talks about the full costs of owning mutual funds, he includes the transactions costs into his calculations.

Most funds do not have anywhere near TFS Market Neutral’s transaction costs, but the TFS fund serves as a good example as to why it is important to understand what you are actually paying.

When reviewing your costs, ask yourself what value you are getting for the expenses. It’s perfectly logical to spend more on a fund that gets you a desired allocation or rate of return. It’s also perfectly logical to spend on a service or a newsletter that helps you make better investment decisions. Some investors may even benefit monetarily from paying a financial adviser to help keep them on track.

What you want to cut out are unnecessary costs or investments that can be replaced with a cheaper alternative (e.g., an S&P 500 index fund instead of a large-cap fund that hasn’t outpaced the index by a wide enough margin to justify its higher expenses). By doing so, you not only save money right now, you also will increase your wealth in the years to come.