The Basics of Investment Fees
Investment fees can be broken down into two main categories: Expense Ratios and Sales Loads. Expense Ratios are fees that you pay annually to cover the expenses of managing a mutual fund or exchange-traded fund (ETF). Sales Loads are fees charged when you buy or sell shares of a mutual fund through a broker. These charges are usually a percentage of the amount invested, and they go towards paying the broker for their services.
The expense ratio is the most common fee charged by mutual funds and ETFs. This fee is calculated as a percentage of a fund’s assets under management (AUM) and is deducted annually from the fund’s net assets. Expense ratios cover the cost of managing the fund, including administrative expenses, marketing costs, and other expenses associated with operating a fund. The average expense ratio for mutual funds and ETFs is around 0.75%, according to Morningstar.
Sales loads are charged when you buy or sell shares of a mutual fund through a broker. There are two types of sales loads: Front-End Loads and Back-End Loads. A front-end load is charged when you buy shares of a mutual fund. This fee is subtracted from your initial investment before the remaining amount is invested in the fund. A back-end load, also known as a contingent deferred sales charge (CDSC), is charged when you sell shares of a mutual fund. The amount of the back-end load decreases over time and eventually goes to zero after a specific holding period.
How Investment Fees Affect Your Portfolio Performance
Investment fees are essential to understand because they can significantly affect your portfolio performance over time. Over the long term, even small differences in fees can add up and have a dramatic impact on your investment returns. For example, suppose you invest $10,000 with an annual return of 7% over 30 years. If you pay a 1% fee annually, your investment will grow to approximately $57,000. However, if you pay a 2% fee annually, your investment will only grow to approximately $41,000. That’s a difference of $16,000.
Expense ratios are the most significant factor impacting your portfolio performance. According to Morningstar, a mutual fund’s expense ratio is the best predictor of future fund performance. Funds with lower fees tend to outperform funds with higher fees over time. Another way fees impact your portfolio performance is through compounding. Over time, the difference between a fund with a 1% expense ratio and a fund with a 2% expense ratio can add up to thousands, if not millions, of dollars in lost returns.
Sales loads also impact your portfolio performance. Front-end loads are charged when you buy shares of a mutual fund, meaning you’re starting your investment journey with a negative return. This charge can offset any positive returns your investment generates in the short term. Back-end loads are charged when you sell shares of a mutual fund, and they can discourage investors from selling their shares, even if it’s in their best interest to do so.
How to Minimize Investment Fees
Minimizing investment fees is essential to maximize your investment returns over time. Here are some tips to keep your investment fees low:
- Invest in low-cost funds: Look for mutual funds and ETFs with low expense ratios. These funds tend to outperform their higher-cost competitors over time. Vanguard and Fidelity are two popular companies that offer a wide range of low-cost investment options.
- Invest in no-load funds: No-load funds don’t charge sales loads when you buy or sell shares. You can buy and sell shares of these funds for free through the company that manages them.
- Invest directly with the fund company: Some mutual fund companies allow you to invest directly with them, bypassing the need for a broker. This can save you money on sales loads charged by brokers.
- Avoid unnecessary trading: Frequent trading can result in high transaction fees and taxes. Stick to a buy-and-hold strategy to keep your investment costs low.
- Use a robo-advisor: Robo-advisors are online investment management services that use algorithms to manage your portfolio. They tend to have lower fees than traditional financial advisors.
The Bottom Line
Investment fees are an essential factor to consider when building a diversified investment portfolio. Understanding how they work and how they affect your investment performance is essential to achieving your investment goals. By minimizing fees and investing in low-cost, diversified funds, you can maximize your investment returns over time.
- Investment fees can be broken down into two main categories: Expense Ratios and Sales Loads.
- The expense ratio is the most common fee charged by mutual funds and ETFs and is deducted annually from the fund’s net assets.
- Sales loads are charged when you buy or sell shares of a mutual fund through a broker.
- Expense ratios are the most significant factor impacting your portfolio performance.
- Minimizing investment fees is essential to maximize your investment returns over time.