The More You Pay, The Less You Get

Normally, we expect higher-priced products to perform better. Not so with expensive portfolio management, which drives down returns.

Higher priced products and services generally tend to have better quality and performance than lower priced products and services. In your investments, however, the opposite is true: when you pay Mercedes prices, you generally get the performance of a Yugo. Let’s look at a few concrete examples of fees impacting performance. We’ll focus on the landmine–mutual funds.

As you recall from the last two articles, the expense ratio (ER) in a mutual fund reflects the administrative and management expenses of the fund. The average US mutual fund had an ER of 1.66% in 2008. Suppose you invested $100,000 at the beginning of 1989 in US stocks (S&P 500 index). The chart to the right shows the growth of that $100,000 over the last 20 years with different expense ratios.

Using an average annual US mutual fund expense ratio of 1.66% would have reduced your overall performance over the 20 year period by almost 25% compared to using a low cost mutual fund with an ER of 0.25%. Throw in a pesky 12b-1 fee of 0.25% on top of the average ER and you’re down 30 percent compared to the low cost fund.

Commissions
Let’s take a look at one type of commission known as a load on a mutual fund. A load is simply an upfront commission. In other words, if you have a 5% load and you invest $100,000 in a mutual fund, you are really only investing $95,000 in the fund.

Now here is the really disgusting part. If you invest $100,000 in a 5% load mutual fund and assume the fund has an annual expense ratio of 1.5% (near the average US mutual fund for 2008) and assuming you receive the same return as the US stock market over the past 20 years, here is what your $100,000 would have grown into $354,849 vs. $478,977 without the load. In other words, the 5% upfront commission coupled with the average expense ratio would have cost you about as much as a Mercedes SL roadster (MSRP $135,000) over 20 years.

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Total fees (as shown in Table 2) can easily add up to 3% or more per year. If you think the 5% load graph looks bad, adding total fees into the equation makes it look downright ugly. Now we’re talking about giving up a Ferrari or maybe even a house.

click on image to view high/res pdf

After deciding on your asset allocation and broadly diversifying your portfolio, reducing investment fees is critical to capturing returns. Your investment returns are inversely proportional to fees and expenses. If you are managing your own portfolio, look over your past year’s statements and add up all of the commissions, taxes, and mutual fund expenses you have paid. If you use an advisor, also look over your statements and see whether you have any load mutual funds or 12b-1 fees and how often your advisor is trading within your account. After all, in the end, costs matter.

-Reduce trading frequency
-Consider discount brokers with low trading commissions
-Consider Dividend Reinvestment Plans (DRIPs)

-Consolidate accounts at one mutual fund company
-Avoid buying funds with redemption fees
-Consider placing a round trip buy/sell called an exchange

-Consolidate accounts at one mutual fund company or brokerage firm

-Avoid commission based advisors
-Use advisors who charge you a fee directly

-Reduce trading frequency
-Buy and sell only stocks with high trading volume
-Buy mutual funds instead of individual stocks
Taxes   
-Avoid short term trading
-Hold on to investments for at least one year before selling
-Reduce dividend paying stocks in taxable accounts
-Choose mutual funds with low turnover.

-Choose mutual funds with expense ratios < 0.50%

-These are useless. Avoid any mutual fund with this fee.

-Buy only no load funds
-Use advisors who charge you a fee directly instead of commissions

Setu Mazumdar MD practices emergency medicine in Atlanta, GA and is the president of Lotus Wealth Solutions. www.lotuswealthsolutions.com