Why fees matter in long-term investment performance

Among the more heavily scrutinized aspects of investment management is the amount of fees charged, whether it is an actively managed mutual fund charging as much as 4% per year or an investment advisor charging 1%. The fact is, in the long-term performance of investment accounts, fees do matter; and the failure by investors to select investment options that offer the optimal balance of performance potential and investment costs could cost them hundreds of thousands of dollars over the course of 20 or 30 years.  

Can higher investment fees ever be justified? 

The difference in the amount of investment fees charges is based largely on the investment method or objective of the investment manager. For example, a fund that is actively managed, with the manager buying and selling securities in an effort to outperform the market, charges higher fees than a fund that is passively managed, where the manager simply attempts to replicate a stock index. The more aggressively a fund is managed, the more it charges.  

The question this poses for investors is where they should expect to get the biggest bang for the buck when considering all factors, including performance potential and the reasonableness of fees.  

Active managers struggle to beat the market

If the actively managed stock fund consistently outperforms the market, then, perhaps, there is no issue. However, according to Morningstar, which tracks the entire universe of mutual funds, as many as 90 percent of active fund managers failed to outperform their market benchmarks each year for the last five years. For the last several decades, low-cost, passively managed funds have consistently outperformed higher-cost active funds in total net performance. A primary contributing factor in the results has been the difference in fees.  

For example, for an active manager to outperform the market by 1%, he would need to generate an excess return of 3% just to overcome the average 2% fund costs. The real hurdle the active manager must clear is closer to 5% after all investment costs are considered. 

Understanding the impact of fees on performance

Investors who truly understand the impact of fees on investment performance might have a better grasp of the criteria t hat should guide the selection of investment options. All one really needs to understand are examples such as this:

$100,000 invested over 30 years

Assumed 6.5% annualized return

 
3% fee 2% fee 1% fee
$280,067 $370,453 $490,839
 

In this example, it can be argued that an investment option that charges two to three times more in fees than another investment option has deliberately impeded the ability of an investor to accumulate needed retirement capital.  

While a small percentage of active managers do outperform the market, the challenge is to be able to select which manager will do so. The same study shows that less than 25% of the best performing active managers are able to repeat their performance consistently. Based on the Morningstar data, investors can substantially improve their long-term performance simply by investing in passively managed investments, such as exchange-traded funds or index funds.

 

Author: Vitali Butbaev, Velstand Capital Founder
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