In my last article I discussed some ways you can lower your disability insurance premiums. Now let’s turn our attention to a more exciting topic: investments. Going along with the previous theme, there are ways you can reduce your investment costs and maybe boost your bottom line at the same time:
Lower the expense ratio
The expense ratio is the management fee a mutual fund charges to its shareholders and is expressed as a percentage of assets. You can find the expense ratios for the mutual funds you own by going directly to each fund’s website. Various studies have shown that funds with lower expense ratios tend to have higher returns than ones with higher expense ratios. Your overall goal should be to have an average expense ratio across all funds of less than 0.5%.
Load up on index funds
Finding funds with low expense ratios shouldn’t be too difficult if you use index funds, which are mutual funds that track a particular market index such as U.S. large company stocks or international stocks. Broad based index funds can have expense ratios less than 0.2% or even 0.1%. Plus index funds tend to have higher returns than the average mutual fund.
Dump your actively managed funds
Actively managed mutual funds try to outperform the market through various techniques such as security selection, market timing, economic and fundamental analysis and others. Whether in up markets, down markets, U.S. stock markets, international stock markets, or bond markets, the results are pretty much the same — actively managed funds underperform in the index. This can be attributed primarily to two reasons: higher expenses and lack of skill. If you’re stuck in an employer 401k plan with actively managed funds, pester your administrators until they replace them with index funds.
Unload the load
If you’ve hired a financial advisor, check to see if he’s sold commission based (load) mutual funds to you. One way to know is to look up the ticker symbol of the fund or see if the fund description has letters A, B, or C at the end. Those letters might mean that you’ve paid an upfront commission (with the A shares for example) when your bought the fund. If you’ve bought the fund in a tax deferred account, think about replacing the fund with a no load fund in the same asset class. And while you’re at it see if you can get the institutional share class of the fund. Institutional shares usually have lower expense ratios than the equivalent investor shares.
Stop trading frequently
Trading individual stocks and bonds can have a number of associated costs including custodian transaction fees and bid-ask spreads so trading less frequently automatically reduces your investment costs. If you’re using mutual funds and regularly contributing to an account, you should think about waiting to make purchases until you build up a larger amount of cash. This means you’ll have less frequent, but larger dollar amount transactions in the year. For example, instead of making 10 buy trades of $1,000, you could make two total buy trades of $5,000 each. That would save on the transaction costs. Of course you have to weigh this against the opportunity cost of waiting and missing out on potential gains with the money sitting in cash longer.
Get tax efficient
If you own a combination of taxable and tax deferred accounts, you should consider placing less tax efficient investments in the tax deferred accounts and the more tax efficient investments in the taxable accounts. Doing so may boost after-tax returns. You should also consider using tax managed mutual funds or exchange traded funds (ETFs) whose structure can have inherent tax efficiency.
Don’t mix investing with insurance
Insurance salesman might consider this blasphemy, but I’ll say it anyway. Do not mix investing and insurance. There are many life insurance and other insurance products out there that have an investment component inside an insurance wrapper. While life insurance is essential — especially when you’re younger — adding an investment component to it will increase your investment cost. Yes, there can be some reasons you need a permanent life insurance policy and you can’t just look at the cost without considering the benefit, but the cost of the insurance tends to dampen the investment returns so much that you’re probably better off keeping insurance and investing separate.
Let’s see how you can apply some of these concepts to your portfolio. Suppose you’re a 45-year-old EM physician making $300,000 gross income as an independent contractor.
I’ll assume about one third of your income goes to the government and you spend 75% of the rest, leaving you with about $50,000 to save annually in a SEP IRA.
While you could spread out the $50,000 in savings to about $4,000 per month, that could result in more transaction costs (12) than either investing the entire $50,000 as one lump sum or perhaps doing it quarterly.
Let’s also suppose your investment portfolio is $500,000 (reasonable for an EM physician this age) and consists of the following mutual funds: Franklin Rising Dividends Fund A (FRDPX), Artisan International Fund Institutional (APHKX) and Metropolitan West Total Return Bond Fund (MWTNX).
Here’s a possible solution for you to lower your investment costs:
|Current Fund||Expense Ratio||Replacement Fund||Expense Ratio|
|Franklin Rising Dividends A||0.9%||Vanguard Total Stock Market Index Admiral||.04%|
|Artisan International Value Institutional||1.02%||Schwab International Equity ETF||.06%|
|Metropolitan West Total Return Bond Fund Admin Class||0.79%||Fidelity US Bond Index Premium||
The replacement funds accomplish several goals all at once: lower expense ratios, conversion from actively managed funds to index funds, no loads and more tax efficiency if you hold the stock funds in a taxable account.
Your total savings on your $500,000 portfolio is over $4,000 annually just from lower fund expenses and about $400 annually on the new savings.