Investing

'You can control the fees that you pay' for investments, says ETF firm CEO: Here's the best way

"You can't control the market or how the IRS is going to tax you, but you can control the fees that you pay."

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Kelly Rowland, Beyonce Knowles and Michelle Williams of Destiny's Child perform during the Pepsi Super Bowl XLVII Halftime Show at Mercedes-Benz Superdome on February 3, 2013 in New Orleans, Louisiana.
Christopher Polk | Getty Images Entertainment | Getty Images

Look just about anywhere in the world of investing, and you'll find a topic that's up for debate. Are stocks overvalued? Will Gen Z investors be able to earn a decent return? Should I experiment with investing in dogecoin? There are few clear answers.

One point that's not up for debate, no matter who you ask: Fund fees are coming down, and that's good news for investors.

According to the latest Morningstar fund fee study, the average expense ratio for U.S. mutual funds and exchange-traded funds was just 0.45% in 2019, nearly half of what it was two decades earlier (0.87%). The shift comes as fund providers have slashed fees on index funds and ETFs to practically, or in some cases literally, nothing, in the hopes of attracting investor dollars.

"Fees are really important — they matter a lot in long-term investing," says Will Rhind, CEO of ETF firm GraniteShares. "And cost is something that you can control. You can't control the market or how the IRS is going to tax you, but you can control the fees that you pay."

The best way to keep costs under control: investing in a passive fund. Passively managed funds seek to replicate the performance of an index, and because they needn't pay a high-priced fund manager to trade in and out of positions, the portfolios come cheap. On average, active funds charged an expense ratio of 0.66% in 2019. The average cost among passive funds was just 0.13%.

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Cost-conscious investors can pay even less. Fidelity customers, for example, have access to four mutual funds that track large swaths of the market and charge no expense ratio at all. Customers at other brokerages can get exposure to major indexes, such as the S&P 500, through ETFs that charge as little as 0.03%.

And even though billions of dollars are spent by financial institutions trying to figure out how funds can provide superior returns, it's the little numbers that count over the long term for investors. "The only data point we've found that is in any way reliable in predicting future fund success is fees," says Ben Johnson, director of global ETF research at Morningstar.

How high fees erode long-term investing results

Consider three young investors: Michelle, Kelly, and Beyoncé. Let's say they all begin investing at 22 with $1,000, with the goal of retiring at 67. They each then contribute $5,000 per year. Michelle invests in an average active fund, which charges a 0.66% expense ratio each year. Kelly invests in a passive fund and pays 0.13% in fees. Beyoncé invests in the cheapest fund, with expenses of just 0.03%.

Over a 45-year investing period, each of their funds earns an identical annualized 8% return.

But because their expenses are different, even by fractions of a percentage point, their long-term results vary drastically. Michelle's investment grows to more than $1.7 million at the end of the period, and over that time she pays nearly $400,000 in fees. Kelly ends up with about $2 million, having paid about $85,000 in fees. Beyoncé comes out on top, with a final total of nearly $2.1 million, with total expenses of less than $20,000.

For Michelle's fund to outshine Beyonce's over the course of their investing lives, one of two things would have to happen — and they both involve Michelle taking extra risk.

Assuming she continues to earn the hypothetical 8%, Michelle could aim to keep working longer. For her fund to eclipse Beyonce's total, she'd have to delay retirement by three years, which, in the real world, means more time in a market that's prone to short-term ups and downs. Plus, extenuating circumstances may make delaying retirement impossible. Nearly half of workers — 48% — end up retiring earlier than expected due to factors such as illness, layoffs, or family caregiving, according to the Employee Benefit Research Institute.

Or Michelle's active manager could beat the index over the long term. If her fund earned an annualized 8.7% per year instead of 8%, she'd come out richer. Of course, generally, aiming for bigger investment returns requires an investor to take on more risk, and historically, few managers are able to do it successfully. In the 15-year time span that ended in 2019, only 37% of mutual funds invested in U.S. stocks outstripped their benchmark index in a given year, on average, according to Morningstar.

To quote Warren Buffett, an outspoken advocate for passive investing, "Active investing as a whole is certain to lead to worse-than-average results." 

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