Investment Costs

Investment costs can have a dramatic impact on long-term returns. Management and advisory fees, custodial and administrative fees, and the costs of transacting are all constant drags on performance. Management fees and transactions costs are typically much higher for actively managed strategies, but these higher costs unfortunately don’t often lead to higher returns.

In the mutual fund world Morningstar has identified only one consistent predictor of relative future performance in its decades of analyzing funds – fees. Funds with lower expense ratios, which are typically those following more passive, index-like strategies, tend to outperform their peers (for a discussion of the merits of active versus passive management please see “The Zero-Sum Game”).

Trading costs are not typically considered when comparing mutual fund expenses, but there effects on performance can be significant. Commissions and bid-ask spreads, particularly in less liquid, small-cap stocks, add up. Most funds can add market impact to the list of costs, as they often trade in sizes that move prices against them.

The chart below demonstrates the impact a seemingly small difference in costs can have on wealth accumulation over the long term:

This chart compares the growth of an initial $1000 investment over a 30 year period, using an assumed 8% underlying annual return and three different investment cost assumptions. As can be seen, the compound effect of a seemingly small difference in investment costs is dramatic. The cumulative wealth accruing in the low cost scenario (far left - annual costs of 0.2%), is 66% higher than the ending value in the high cost (far right – annual costs of 2.0%) scenario.

The investment costs used in the analysis above were not chosen at random. The low cost figure of 0.2% is the approximate annual combined costs, excluding advisory fees, of a broad-based asset allocation strategy using index mutual funds and ETFs. The high cost figure of 2.0% is the estimated average cost of employing the same strategy using actively managed funds.

To be fair, the additional costs of active management come with the chance of bettering the index return. Of course they also come with the chance of doing worse, and unfortunately history (and mathematics) tells us they usually do. Win or lose, though, the higher costs will be deducted.