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| The Hidden Impact of Mutual Fund Fees |
Submitted by:
Tip Hero 11/11/2008 7:59 AM
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I recently came across an excellent online calculator that allows you to compare the impact mutual fund fees have on your portfolio over time. While I have always known that fees have an impact on your overall results, I never fully realized just how large an impact they actually have.
The online mutual fund fee calculator from Canada's Investor Education Fund (link below) allows you to compare two funds side by side. To test it out I decided to run a scenario whereby an investor invests $35,000 on his 35th birthday and cashes out the investment when he retires on his 65th birthday.
I wanted to compare the impact of an actively managed mutual fund versus an index fund. I hopped on over to Vanguard's website and picked their total stock market index fund which has an annual fee of 0.15% and compared it to an actively managed fund with an expense ratio of 1.18% which Vanguard cited as the average fee for mutual funds in this category. One additional assumption I made was that each fund would average a 9% annualized return over the 30 years my fictional investor held these funds. I've included the results from this scenario below. "Fund 1" is the actively managed fund, and "Fund 2" is the Vanguard index fund:
The Hidden Impact of Fees
What surprised me most about the results, and something I never really took into full consideration, is the fact that it isn't the fees you pay where you take the biggest hit but rather the lost return potential from those fees. In the results above you can see that the total fees in Fund 1 (the actively managed fund) came to just under $47k but the lost return potential was more than $87k. If you extended the holding period of the investment by just two years, from 30 to 32 years, the lost return potential costs would be more than twice the cost of the fees. The end result is that when our fictional investor goes to cash in his investments, Fund 2 (the Vanguard index fund) would have yielded him a little more than $114k or 26% more than the actively managed mutual fund.
The Other Hidden Cost
One element I didn't model in this scenario is the returns of actively managed funds versus indexed funds. As John Bogle and Warren Buffett have often stated, very few actively managed funds beat their comparative index over long periods of time. There are always some mutual fund managers that are able to beat their respective indexes but picking the winning mutual fund manager is, to a great degree, luck.
I've seen statistics as high as 90%, representing the percentage of actively managed funds that don't out-perform their respective indexes over a ten year period. To state this inversely you have a 90% chance of beating actively managed mutual funds if you simply just choose an index fund.
It is for all of these reasons that Warren Buffett highly recommends that the average investor invest in index funds rather than individual equities or actively managed funds.
For most folks with decent sized investment portfolios and many years before retirement, the hidden impact of investment fees is going to be one of the biggest expenses they face in their lives. I highly recommend taking some time to play around with the online calculator from the Investor Education Fund below. Please also forward this article to your friends so they can learn about the full impact of mutual fund fees.
Here's the link to the Mutual Fund Fee Calculator
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