Mon 13 Aug 2007
Posted by admin under Investing
Guy: I don’t know much about ETFs, I just invest in a mutual fund.
Me: What kind of fees are they charging you?
Guy: I’m not sure, but their performance has been pretty great in the past couple years.
Me: You don’t even know how much money they are charging you?
As promised, here is the breakdown of why you should be at least a little familiar with your mutual fund’s management fees. First, a quick blurb about capital gains.
Capital Gains - The profit that is generated as a result from the appreciation of a capital asset over its purchase price. If you but $1,000 worth of stock and sell it for $1,100, you have $100 in capital gains. The $100 in capital gains is what you pay taxes on.
If you held the security for longer than one year (long term capital gain), your capital gains are taxed at a maximum rate of 15%; if you held for less than a year (short term capital gain), you can be taxed up to 28% on your earnings.
Your goal should be to purchase a security that will appreciate in value over an extended period of time to minimize taxes. But what about mutual funds that purchase stocks for capital gains? They have overhead expenses for their employees, the buildings they work in, their computers, and the fund needs to advertise; how do they pay these costs? Enter management fees.
Costs are the biggest problem with mutual funds. These costs eat into your return, and they are the main reason why the majority of funds end up with sub-par performance. (Source: Investopedia)
Take a look at Fidelity’s International Discovery Fund. If you scroll down, you can see their ‘Expenses & Fees’ section that clearly states that their expense ration is 1.09% vs the industry average for this class of mutual fund of 1.51%.
What does that mean? It means that for every $100 you have in their fund, you pay them $1.09 per year for them to manage your holdings. I really like Fidelity; they manage my 401K and offer a great selection of investments. I also greatly admire the fact that they are VERY upfront with their expenses, their returns, and their holdings. But shouldn’t I be a little skeptical about the costs they are charging me?
Most people don’t think that much about how these expenses can change their overall portfolio performance…I do. The expense ratio for the Vanguard Emerging Market ETF is 0.3%, it is also listed right near the top of the page. So, the industry average for an international fund is 1.51%, another great fund charges 1.09%, and an international ETF charges 0.3%. There has to be a reason one would choose a higher management fee; these funds must employ more talented individuals, they must have higher performance or something….right? Actually, the historical performance of mutual funds and ETFs are virtually identical. But we are talking about a difference of a respective .42 and 1.21%, that doesn’t even make that big a difference…does it?
Why pay more money for almost identical performance? Fine, we’ll crunch the numbers.
Lets take two recent college grads at 25 and assume they put $2,000/yr into an investment account. One chooses the ETF and one chooses the mutual fund. The average performance of both funds is 11%. Where will they stand in in 30 years at age 55? I’ll also go ahead and plug the numbers for an annual contribution of $4,000.(Figures found using the compound interest calculator)
So after 40 years, our low cost ETF beats first mutual fund by $265,939 at 2K/yr and by $531,879/yr at 4K/yr. Our ETF beats the second fund by $383,665 at 2K/yr and $767,329/yr at 4K/yr. I guess the real question is whether or not 10 minutes of math and plugging a few numbers into a calculator is worth $767,329. Even if you are horrible at math and it took you an entire month to figure out this concept, it would yield you over $1,031/hr. ($767,329/(31*24)) Tell you what? The first five people to e-mail me at email@example.com with the e-mail title ‘I would like $700,000′ will get a hours worth of my time to explain how badly fees rape you. I won’t charge you $700,000/hr…I’ll do it for free.
In case all that math was too much, I just showed you how you could get an extra $700,000 for retirement, a heck of a lot of booze, or for my personal choice which is a year long vacation during which I ‘have’ to spend $2,000/day…life sure is hard!
In terms of annual fees, how much would the ETF and our two mutual funds be charging per year 40 years down the line?
If you took the smart route and saved $4,000/yr.
ETF Fee: $7,817.69/yr
Mutual Fund 1 Fee: $22,606.79/yr
Mutual Fund 2 Fee: $27,762.36
Look, I’m not telling you to be a crazy math dork (like me) or even to make immediate changes to your investment…just do a little research so that you have an understanding of how a little fee of 1% really can make a difference in your finances.
Ohh, and guy, that difference also applies to that 1% savings account you told me about, you can find superior rates at:
Emigrant Direct: 5.05%
(Rates as of 08/13/07)
With a simple account transfer, you could easily be earning AT LEAST four-five times as much interest…just a thought!
Measuring Equivalence of ETFs Versus Mutual Funds
Tools For Evaluating Index ETF vs. Mutual Fund Purchases
Mutual Funds: 14 Mutual Fund Questions That Every Investor Should Know How to Answer
Choosing the Right ETF: Growth Versus Value in Asset Allocation