How Fund Fees Is Silently Killing Your Returns

Fees — Your Fund Expense Ratio

There are many different types of fees. The bulk of it is lumped inside this thing called the fund expense ratio. It captures most fund-related expenses including the management fees and other stuff. What is not included in this expense ratio is the sales charge you pay to advisors or brokers who sold you the fund. But, not all funds have a sales charge. And in the case of hedge funds, which are open only to the high net worths and institutions, they have another fee called the performance fee. This fee takes the form of a cut on the profits they make for you. On top of these, trading related transaction costs incurred by the fund buying and selling securities are not inside as well.

Average Expense Ratios as of 31 Dec 2019 (Source: Wikipedia)

Why Should You Care About The Fees?

The reason is simple. They eat into your profits, and often way more than what most laymen think. A “harmless” looking 1% can take a huge slice off your profits over time. Because the annual fee can be deducted daily, and what you lose at the end is also not just the fees you paid to the fund manager, but also the loss of potential profits on the fees paid.

Pay Only What It Is Worth

So is it wrong for funds to charge fees? Absolutely not. You can’t expect businesses to provide you services free of charge. They have mouths to feed too. But you need to be discerning about what you are paying for and how much you are paying. If you are capable of doing what they do or better, then it makes sense to do it yourself. But of course, you can still opt for the easy way out and let them do the work for you. But paying a couple of hundred grand for that just sound too exorbitant.

Does the fund manager have the skills?

For an actively managed fund, we want to see the value add from the manager’s active management. By value-add, I don’t mean the manager making more in terms of absolute returns. Many people mistook that as simply making more money. No, that is not it. Because you can beat a stock index that has a decent positive long term growth by taking on more risks. For example, you may concentrate risks on technology stocks, or use a little bit of leverage (but not excessive). But, getting more returns with more risk is a given. That has nothing to do with skills.

Are the funds doing what you need?

You have to find one that addresses your needs. If you are already sitting on a good size stock portfolio, then maybe you want to look for a bond fund to spread out the risk. Or if you just want passive exposure to a particular market, then you should be looking at low-cost index funds rather than the actively managed funds. Or perhaps you are already a seasoned investor and looking to add an uncorrelated strategy to your current portfolio. Then a typical run of the mill long-only mutual fund is unlikely to meet your requirements. You will then need to look into alternative funds such as hedge funds.

Is the fund doing something I can do myself?

Many people thought professional funds are doing things that are out of reach. Because there is always this lingering thought that what they do must be rocket science and require a ton of resources. If you think along such lines as well, you will be surprised that some strategies are well within reach of the common man. This is made possible with the advent of low-cost index funds and ETFs, as well as ever-lower brokerage fees. For example, asset allocation type strategies are no longer off bounds. So is trend following, a popular strategy adopted by Commodity Trading Advisors (CTAs) for decades. And there are many more. Technically, these aren’t that difficult to understand or implement. In such instances, doing it yourself not only puts you in charge but saves you a significant amount of fees over the long run too.

Parting Thoughts

Traditional means of setting fees are based on a fixed percentage of the fund’s asset size. This is not something unique to fund management companies. Many service providers revolving around fund management also charge their fees in the same manner e.g. brokers, fund custodians, fund administrators.

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