Sixty-one percent of Americans don't know how much they pay in investment fees, according to a recent report by Personal Capital. And about one-third of people also believe that higher fees for investments generally translates into higher returns.
The reality is that high investment fees can cost you lots of money on your investment returns, and it's important for all investors to understand what investment fees they're paying and what they can do over the long run.
What kind of fees could you be paying?
There are two major types of fees that investors who own mutual funds or use a financial advisor should be aware of.
The first is known as the expense ratio, which is the cost of owning a certain mutual fund or exchange-traded fund, expressed as a percentage of the fund's assets. For example, an expense ratio of 1% means that if you have $10,000 invested in a certain mutual fund, you're paying $100 in annual investment fees. This covers expenses such as the fund managers' salaries, as well as any administrative costs of operating the fund. Mutual fund expenses can also include sales charges, although these are becoming less and less common.
It's also important to mention that all mutual fund products have some type of expense ratio -- even those held in your 401(k) or similar retirement plan. It's a common misconception that 401(k) investments don't cost anything. They do.
The second major type of fee is known as an advisory fee, which is generally also a percentage of assets under management. Like expense ratios, advisory fees can vary considerably, but 1%-2% of assets is typical. This is on top of any fees charged by the funds you advisor chooses to invest in.
For example, Personal Capital's report found that a certain well-known investment advisory firm charges clients an advisory fee of 1%-2% and the average fee charged by the funds in its clients' accounts is 0.33%. This translates to a total fee of 1.33%-2.33%.
Some fees are OK, but be aware of the difference they can make
I'm not saying fees are inherently bad. In fact, many financial advisors provide other services at no additional cost, such as insurance and estate-planning advice. If you feel like your advisor is truly earning their fee, it can certainly be money well spent.
My point, rather, is that excessive fees should be avoided. An example of an excessive fee would be paying a financial advisor 1.5%, when you could get the same services for 1%. Or investing in a mutual fund with a 0.80% expense ratio, when there are similar products that accomplish the same objective for a fraction of the cost.
Here's why this is so important. Let's say you invest $10,000 per year, and that your investments earn an average total return of 7% each year, before expenses. If you pay total fees of 1% (advisory plus fund expenses), you can expect to have a nest egg of about $1,114,000 after 30 years. On the other hand, if you pay total fees of 2%, your investments would build up to $903,000 -- a full $211,000 less. Paying higher fees can literally cost you hundreds of thousands of dollars.
The Foolish bottom line on investment fees
In his 2016 letter to Berkshire Hathaway's shareholders, Warren Buffett wrote, "When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsize profits, not the clients."
In other words, while many Americans think that high-fee investments produce better returns, the opposite is often true. High fees generally have the effect of making someone else rich -- not you.
Conversely, the lower your investment fees, the more your profits that will stay in your investment account, which can produce a pretty amazing compounding effect over time. Whether you're choosing your 401(k) investments, looking for a financial advisor, or thinking about investing in mutual funds or ETFs on your own, the fees should be a major part of your decision process.