Most investors focus on price appreciation when it comes to growing their portfolios. For this reason, we pay close attention to the prices of the stocks, mutual funds and exchange-traded funds (ETFs) we own and how they change over time.
However, for fund owners, there is an oft-overlooked element that, over time, can also have an impact on performance.
You have undoubtedly heard the saying, “there is no such thing as a free lunch.” When you are investing, especially in mutual funds, there are usually multiple costs to ownership—the price you pay when buying a fund and the fees and expenses of owning it.
Many investors do not give much attention to how much they are paying to own a mutual fund. Unfortunately, that could be an expensive mistake because these investment costs add up, compounding right along with your investment returns.
The fees and costs associated with owning funds may seem small, but they can have a major impact on your investment performance over time. This is because you not only lose the “small” amount of fees you pay, but you also give up the growth of the money you are paying in fees over the life of holding the fund.
Here’s an example. Imagine you have $100,000 to invest. If the account earned 4% a year for the next 20 years and had no costs or fees, you would end up with more than $219,000 ($219,112.31, to be exact).
If you invested your $100,000 in a fund with an annual fee of 0.5%, this would cost you more than $10,000 on a $100,000 investment ($10,489.56). Compared to investing at 4% a year with no fees, this would lower your end balance to $208,622.75. In addition, because of the impact of compounding, this 0.5% annual fee would reduce your portfolio value by 4.8% over 20 years had you been able to invest what you are paying in fees.
If you paid 1% a year in costs over 20 years, this would lower your portfolio value by 10% ($197,093.31 versus $219,112.31).
Some funds charge annual fees of 2% or higher, which would reduce your portfolio value by more than 22% over 20 years by not investing what you are paying in fees. So that seemingly innocuous 2% cost turns into serious money.
Because all investments have costs, it might seem like there is no need to worry about them. Some people even believe that “you get what you pay for” and assume that a higher fee means higher quality.
Research tells a vastly different story: higher-cost funds generally underperform lower-cost funds. For example, in an article from The Wall Street Journal in January 2019, Derek Horstmeyer presented research on the performance of high-fee actively traded mutual funds (those with an expense ratio over 1.5%). Horstmeyer’s analysis showed that, over the 10 years ended in the third quarter of 2018, the average high-fee fund delivered an average annual return of 10.61% after expenses, while low-fee funds averaged 12.26%—a difference of 1.65 percentage points. Over 20 years, that 1.65-percentage-point difference would amount to more than $38,700 on a $100,000 investment.
Fees typically come in two types—transaction fees and ongoing fees. Transaction fees are charged each time you enter a transaction, for example, when you buy a stock or mutual fund. In contrast, ongoing fees or expenses are charges you regularly incur, such as an annual account maintenance fee.
For some mutual funds, a type of transaction cost is a sales load. Sales loads serve a similar purpose to commissions by compensating the financial professional for selling the mutual fund to you. Sales loads can be front-end in that they are assessed at the time you make your investment, or back-end in that you are assessed the charge if you sell the mutual fund, usually within a specified time frame. Be aware that some funds with very low expense ratios add on these front- and back-end loads.
Mutual funds and ETFs are essentially investment products created and managed by investment professionals. The management and marketing of these investment products result in expenses and costs that are often passed on to investors in fees deducted from the fund’s assets. These ongoing annual fees can include management fees, 12b-1 or distribution (and/or service) fees and other expenses. These fees are often identified as a percentage of the fund’s assets—the fund’s expense ratio (identified in the fund’s prospectus as the total annual fund operating expenses).
The bottom line? The fees and expenses you pay when investing in mutual funds and ETFs can play a role in whether you achieve your financial goals.
However, take heart in knowing that you can, in part, control the costs you pay. So, give them the time and attention they deserve.
Using the A+ Investor Funds Screener reinforces the notion that lower-cost funds perform better than high-cost funds.
For this example, we screened for large-cap growth U.S. equity non-indexed funds that are open to new investors and are not institutional shares.
We then screened for funds with an expense ratio that ranks in the top 10% of its category (highest expense ratios) and the bottom 10% of its category (lowest expense ratios; see the image below).
The expense ratio of a mutual fund is the total percentage of fund assets used for administrative, management, advertising (12b-1) and all other expenses. For example, an expense ratio of 1% per annum means that 1% of the fund’s total assets will be used to cover costs each year.
As of September 30, 2021, 103 U.S. equity large-cap growth non-indexed funds have expense ratios that rank in the top 10% of their categories. Among these 103 funds, 90 have been in existence for at least 10 years. The median 10-year average annual return for the 90 funds in existence for at least 10 years is 17.0%.
The median expense ratio for these 90 funds is 1.87%. Fidelity Advisor Stock Selector All Cap fund 
(FLACX) and Invesco Summit C fund (CSMMX) tied for the lowest expense ratio at 1.74%. In addition, the two funds have an average annual return over the past 10 years of 15.2% and 17.8%, respectively.
For those funds with an expense ratio in the top 10% of its category, the one with the best 10-year performance is Morgan Stanley Insight C fund (MSCMX), with an annualized return over the last 10 years of 24.0%. At the other end of the spectrum, Catalyst Insider Buying C (INSCX) returned 10.4% a year, on average, over the 10 years ended September 30.
Looking at the large-cap growth U.S. equity non-indexed funds that are open to new investors and are not institutional shares that rank in the bottom 10% of their category for expense ratio, there were 61 funds as of September 30, 2021. Among these 61 funds, 36 have been in existence for at least 10 years. The median 10-year return for these 36 funds is 18.2%.
The median expense ratio for these 36 funds is 0.40%. Three of these 36 funds have expense ratios of 0%: Voya Large-Cap Growth (VPLCX), TIAA-CREF Large-Cap Growth (TILWX) and American Century Focused Dynamic Growth (ACFGX). Three funds in the group of 36 tied for the highest expense ratio at 0.53%.
Among this growth of 36 low-cost funds, Franklin DynaTech (FDTRX) had the highest 10-year annualized return at 21.9%. Conversely, Capital Group U.S. Equity (CUSEX) is the laggard among these 36 funds, averaging a return of 14.9% a year over the last 10 years.
Here are the 10 funds from the low-cost group with the highest 10-year annualized return:
This example shows that, on average, lower-cost mutual funds outperform high-cost funds over the long term.
Using the A+ Investor Funds Screener, you can screen for funds with expense ratios that rank very low in the category based on expense ratio.
As the data presented here shows, ignoring the cost of owning a mutual fund can be detrimental to your portfolio’s performance.
