Financial Planning Blog

Benjamin Franklin once observed that, "A small leak can sink a great ship." The same is true for your retirement portfolio--those seemingly small mutual fund expenses can wreak havoc on your long run returns. Even though there are many things you can't control when you are investing in volatile markets, the smart investor can keep costs, and their drag on returns, to a minimum.

In investing, small numbers make a great difference over the long run. For example, $10,000 invested today earning 7% compounded annually will grow to over $76,000 in 30 years. Not bad--but bump this up to only 7.5%, and the total in 30 years is almost $88,000. In other words, that 0.5% incremental return resulted in 15% more funds accumulated. Increase the return up to 8%, and you have almost $101,000--the additional 1% return provided over 32% more at the end. Such is the power of compound interest. (For an interactive, graphical illustration of the impact over time, see Vanguard's "The Truth About Costs".)

Unfortunately, when it comes to mutual fund expenses this power works against us. The costs associated with mutual fund investing act as a drag on our returns. Each dollar spent on investment management, administration, advertising, commissions, or whatever is a one dollar less in our account. Worse yet, it is another dollar that is not out earning and compounding.

Costs are obviously not the only consideration when investing in mutual funds. Investors are really concerned with performance, risk, and exposure to particular asset classes. The lowest cost funds are not always the best performing, nor are high cost funds always lower performing. However, research from Morningstar has shown that costs and performance are linked. For example, funds in the least expensive quintile (20%) are 2.5 times more likely to outperform than those in the most expensive quintile. This should be no real surprise--the more expensive funds need to earn that much more to offset their expenses, so outperforming market averages is even more difficult. (This Vanguard article shows more data regarding the relationship between expense ratios and returns.) Other academic research also backs up this inverse relationship between costs and performance.

When considering the costs of owning mutual funds, the expenses can be broken down into two buckets. First, there are the direct costs that are disclosed and easily quantifiable. These will be discussed in Part 2. In Part 3, the undisclosed, less transparent costs incurred by investors of mutual funds will be examined. These costs are harder to get your arms around but reduce your returns nonetheless.