The advantages of keeping investment costs low

CutexpensesKeeping investment costs low is a vital investment principle.  Investment expenses come directly from your investment return, and over the long-term eat into your wealth accumulation.

Expenses are one aspect of investing that you can control, so understanding the various costs and how they affect investment performance can greatly improve your investment results.

Investment costs

Investment costs come in a variety of forms. If you buy investments from a broker, you will incur sales commissions, known in the mutual fund world as sales loads.   All funds have operating expenses. These  are included in a fund’s expense ratio.

Mutual funds also incur the transactional costs of buying and selling securities.

Sales loads

When buying a load-fund from a broker you will either pay a typical upfront 5% sales load,  or pay a sliding scale redemption fee, accompanied with an additional 1% annual  fee.

With a front-loaded sales fee,  you will pay a $500 sales commission  on a $10,000 initial investment, leaving you with a $9,500 investment in the fund.  You will pay the commission on each of your subsequent purchases of the fund.

With a back-end sales fee, the combination of annual charges and the redemption fee assures the brokerage that it will earn its commission over time.

You can avoid sales commissions by avoiding broker sold load funds.  You can invest in a no-load mutual fund  directly from a no-load  investment management company.

Expense ratio

Mutual funds incur costs for administering and managing an investment portfolio. These expenses accrue daily, and are expressed as a percentage of portfolio net assets.

This percentage figure is known as the expense ratio.

The Investment Company Institute publishes mutual fund expense ratios in annual yearbooks. They provide expense ratio data for the average mutual fund, as well as  the average expense ratio for dollar-weighted investor holdings in mutual funds. The 2014 yearbook  gives us the following expense ratio data:

Category Simple average Dollar-weighted average
Equity funds 1.37% 0.74%
Balanced funds 1.25% 0.80%
Bond funds 1.00% 0.61%

The 2014 ICI yearbook reports that index fund investors paid a dollar-weighted average expense ratio of 0.12% for stock funds and a dollar-weighted average expense ratio of 0.11% for bond funds.

The chart below shows the difference in accumulated value resulting from expense ratio charges. Over a thirty year period, an initial $100,000 investment growing at an annual compound return of 6% will produce a terminal value of $574,349.

  • A low-cost fund with a 0.25% expense ratio will accrue $532, 899  after 30 years.
  • A higher-cost fund with a 0.90% expense ratio will accrue $438,976 after 30 years.

The low-cost fund consumes 7.22% of the thirty year accumulation . The higher-cost fund consumes 23.57% of the thirty year accumulation.

Initial investment: $100,000 at 6% return, reinvested earnings

Transaction costs

In addition to the expense ratio, a  stock mutual fund incurs expenses for buying and selling securities.  These expenses are not included in the expense ratio, but are reflected in the net return of the fund. These costs can be considerable if your fund trades frequently.

Mutual fund transaction costs are measured in a paper published by Edelen, Roger M., Evans, Richard B. and Kadlec, Gregory B., “Scale Effects in Mutual Fund Performance: The Role of Trading Costs” (March 17, 2007).  In the paper, they discover that:

  • Median mutual fund transaction costs have been estimated to measure between 70 and 85 basis points of annual cost drag, ranging from 55 basis points for large cap stocks up to 233 basis points for small cap stocks.
  • Mean transaction costs are estimated at 144 basis points for the average fund, ranging from a mean of 77 basis points for large cap stocks to a mean of 285 basis points for small cap stocks.

Once again, index funds incur much lower transaction expenses than active funds.

Keep in mind that if you invest in exchange-traded funds, you will incur transaction costs and may also incur brokerage commission costs when you buy and sell your funds.

Cost savings add to retirement nest egg

Reducing investment costs can have dramatic effects on your level of retirement spending. As the chart shows, reducing expenses by 1% over a lifetime results in ten years of addition spending capacity during retirement.

 800px-Annual_Return_-_Fee_Impact

Return Assumption Notes

Results are simulated. The saving phase simulates a participant with a salary of $45,000 at age 25, linearly increasing to $85,000 by age 65, making yearly contributions of 6% of salary at age 25, increasing by 0.5% per year to a maximum of 10% and with a 50% company matching contribution up to the first 6% of salary.

In retirement, $63,750 (75% of final salary) is deducted at the beginning of each year. The blue-shaded area shows ending savings with an after cost investment return of 9% assumed at age 25, linearly decreasing to 6% at age 80 and remaining constant thereafter.

Inflation is assumed to be a constant 3%. The tan-shaded area assumes 1% greater return each year due to reducing the costs of investment by 1%. All amounts are in present-day dollars. Source: AllianceBernstein, as presented to the DOL/SEC Hearing On Target Date Funds And Similar Investment Options.

Next post in the investing basics series: Why Index?

About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

Tagged with:
Posted in Investing
September 2014
M T W T F S S
« Aug   Oct »
1234567
891011121314
15161718192021
22232425262728
2930  
Categories
Archives
Follow Financial Page on WordPress.com
%d bloggers like this: