Are you throwing money away? If you are investing, chances are that the answer to this question is yes. Many of us overlook the fees we pay when it comes to our investments. It’s easy to overlook these fees since we never get a bill for them in the mail, and they never show up on our monthly or quarterly statements. They are simply taken out of our investments for us and all we see is our leftover balance.
While this sounds like a great option, it actually costs us more money in the long run since we ignore these fees. With the average mutual fund management fee of 1.40%, you could be costing yourself over $40,000! Read on to learn more about management fees and what you can do to stop throwing money away.
What Are Management Fees?
Before we get into how you can save money on management fees when investing, we first have to understand what management fees are. Management fees are the costs associated with running a mutual fund or exchange traded fund (ETF). Included in this fee is the salary of the fund manager, administrative costs, along with other small miscellaneous costs the mutual fund passes on to its shareholders.
As I pointed out above, the average management fee for equity mutual funds is 1.40%; the majority of this is to pay for the salary of the fund management.
How Are Management Fees Paid?
In its simplest form, management fees are taken from the return of a mutual fund. In other words, if you are investing in a mutual fund with a 1% management fee and that fund returns 8% on its investments, you as an investor see a lower return. In this case, you would see 7% as the net return of the mutual fund. While this 1% doesn’t sound like much, it can be. For every $1,000 you have invested, you are paying $10 to the mutual fund. So if you have $10,000 invested you are paying $100 every single year on this investment. Over the course of 20 years, that’s $2,000 you have spent!
Some reading this might not think that $2,000 over 20 years is a big deal, but you have to remember, I am using 1%, not the average management fee and over time, the value of your investments grows. Additionally, most investors invest in more than one fund or ETF.
If we use the average management fee of 1.40% and we assume you have $50,000 invested, over 20 years you have paid close to $30,000! That is the equivalent to one year’s worth of living expenses in retirement!
Unfortunately, investing in higher expense mutual funds has another money draining effect: opportunity cost. This essentially is the loss of keeping your money invested instead of paying the management fee. If you had kept your money invested, it could grow and compound. But since you paid a management fee, you lost that opportunity. The opportunity cost of the investment fee above cost you an additional $28,000 in potential gains. In total, you lost out on close to $60,000. In other words, the balance of your investments would be $60,000 higher had you not paid these fees.
How To Save Money On Management Fees
Fortunately, it is relatively easy to save money when it comes to management fees. The way you do this is to only invest in mutual funds and ETFs with a low management fee. There is no reason why you should be paying more than 1% on any investment. Note that there is no way to invest in a mutual fund or ETF that doesn’t charge a management fee. To keep your costs as low as possible, look into a passive investment strategy.
To find a particular mutual fund or ETF management fee, all you have to do is look in the prospectus that is required to be given to you when you invest in the fund or ETF. In this booklet, it will list the management fee (sometimes called the expense ratio). The lower this number, the better. Let’s look at a comparison to see how much you really can save.
Comparing Returns With Different Management Fees
We are going to look at two mutual funds, Fund A and Fund B. Fund A has a management fee of 1.02% while Fund B has a management fee of 0.18%. If we were to invest $50,000 in each fund for 25 years and both funds returned the same 8% annually, what would our balance be after the 25 years? Some might think that since we are investing the same amount and both funds earn the same return each year, their ending balances would be the same. But they aren’t, thanks to their management fees.
As you can see, Fund A has a balance of $263,000 while Fund B has a balance of $327,350. That is a difference of over $64,000! Let’s look now at how the management fees play a role in this.
Over these 25 years, if you invested in Fund A, you paid a whopping $34,000 in fees whereas with Fund B, you paid close to $7,000 in fees.
If the fees paid didn’t shock you, take a look at the opportunity cost. With Fund A, you lost the opportunity to stay invested which cost you just over $43,000. With Fund B, you lost the opportunity of roughly $8,000.
If you take the ending values of either fund and add back the management fee and the opportunity cost, you will see that the ending values roughly match up. They won’t exactly match in this example since I rounded some numbers. But it shows you how much of an impact fees have on your investments. The bottom line is that you have to pay attention to the fees you pay. They are costing you more than you think.
When it comes to investing, you have to pay to play. With mutual funds and ETFs, that payment is in the form of annual management fees. The higher that percentage, the more you are paying to invest in that fund. There is no relationship to higher fees and better performance. Therefore, you are better off paying the absolute minimum for your investments. Pay attention to how much you are paying in fees. The less you pay means the more you keep invested and allow to grow over time.
Author Bio: Jon writes for Money Smart Guides , a personal finance blog that helps readers get out of debt and start to invest for their future. There he provides a low cost fee analysis for his readers to help them see just how much they are paying in investment fees.
Photo Attribution: TaxCredits.net