Understanding the (all too often) unfriendly math of investment fees.

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“What happens in the mutual fund business is that the magic of compound interest on returns is overwhelmed by the tyranny of compounding costs.  It’s a mathematical fact.” 
-  Vanguard founder John Bogle).[1]

     Although John Bogle’s warning has been heeded by many investors over the years, far more investors do not realize the degree to which the combined costs of investment advisory fees and mutual fund expenses have the ability to destroy a high percentage of the value of their investments.  Whether its advisory fees, annual mutual fund expenses, load fees, or assorted other fees, these fees can reach two percent or more every year.  Making matters worse, the average stock mutual fund turns over 80% of its underlying portfolio each year, generating taxes, which, on average, take away an additional one percent of the investment return in taxable accounts.[2]

     Assuming that the market is returning seven percent annually, and assuming no fees (or taxes) for the moment, the growth of a hypothetical $750,000 account over twenty five years would result in a total account value of $4,071,000.  In contrast, a five percent annual return results in an ending account value of $2,540,000.   The difference?  A potential reduction of more than one and a half million dollars, or 37% -  more than one-third  - of the entire potential value of the portfolio.  Put another way, this difference of two percent in annual returns wiped out 43% of everything the investor earned in the market over twenty-five years – money the investor will not have in retirement.

    It has been estimated that each one-quarter (.25) percent increase in annual fees can push one’s retirement back by one full year.[3]  The U.S. Department of Labor has also weighed in on the issues of fees, warning 401(k) plan participants that each percent in fees can reduce a worker’s 401(k) balance by 28% over a 35-year working lifetime.[4]  True, fees (and taxes) can never be entirely eliminated – but investors must pay more attention to them, and ensure that they receive more in value from fees than they are giving up.  

     Why do so many investors continue to pay advisory and mutual fund fees that reach levels which open them up to the real risk of giving up forty or fifty percent of their total investment returns?  If the effect of the “tyranny of compound fees” were intuitively obvious, most sensible investors would balk at taking such a course of action. And that’s part of the problem – it is far from intuitively obvious that a two percent difference in annual returns can potentially wipe out almost half of a lifetime of investment returns.  Nevertheless, investors need to start to think in terms of “that’s potentially twenty percent of my profits!” when they hear “one percent in fees.” 

     But even when investors do understand the potential impact of fees, there are other obstacles.  For one, many investors never find out how much they are paying for their mutual funds because the cost of each mutual fund is automatically deducted from the fund’s gross return – and not broken out as a separate expense on the account statement.  In other words, there is no “aha, these are my fees!” moment. True, the annual cost (or in mutual fund parlance, the “expense ratio”) can be found in a fund’s prospectus, buried somewhere within those forty-plus pages, or on websites such as Morningstar, but most investors rarely dig that deep.   But in my own experience, many investors never even remember paying upfront sales commissions that are often as high as five or six percent of the purchase price – in addition to annual expenses.

     And there is another reason – a lack of information about the track record of ultra-low-cost “index” funds that often cost one-tenth as much as many mutual funds.  An index fund is essentially a “passive” fund that attempts to replicate an index such as the S&P 500, or the Dow Jones Industrial Average, as opposed to a mutual fund, which almost always tries to “pick and choose” among various stocks in an index such as the S&P 500 as it attempts to “beat” the performance of that index.  Index funds have an ultra-low cost structure which is about 80-90% less than what actively-managed mutual funds charge.

     Index funds first made their appearance in the 1970’s, when John Bogle founded Vanguard as a result of Nobel laureate Paul Samuelson’s groundbreaking study demonstrating the extreme unlikelihood of mutual funds being able to “beat” the market, as well as his own studies confirming Samuelson’s conclusions.[5]  In his investment classic, Common Sense on Mutual Funds, Bogle demonstrated that index funds did not just provide better returns than mutual funds - they were also less risky.[6]  Bogle’s analysis of twenty five years of data showed that the superior performance of index funds cut across every major sector of the market, from small-cap to large-cap, from value stocks to growth stocks, by an annual average of 1.4%, net of all fees.[7]  Bogle’s conclusions have since been supported by the results of over two hundred academic studies, and Vanguard is now the world’s second largest investment management company as well as the world’s largest seller of index funds.[8]

     If investment fees are so potentially damaging, and so much evidence supports indexing as a superior investment strategy, shouldn’t investors assume that their financial advisor will be telling them this?  Not necessarily.  Most investors don’t realize that ninety percent of financial advice is provided by advisors who are under no legal obligation to put the clients “best interest” ahead of their own.  Such financial advisors fall within the category of brokers or broker-representatives, who are held to a “suitability” standard when providing financial advice.  This includes some of the largest banks and brokerage houses in the country, where millions of investors receive financial advice. 

     As a result, many investors are directed to high-fee mutual funds, or other products that generate much higher revenue for the advisor than ultra-low cost index funds do.  In contrast, less than 10% of financial advice is provided by an investment fiduciary, who must abide by the legal standard of providing financial advice that – at least in theory – must always be in the client's best interest. 

     Many investors find the distinction confusing.  While most individuals walking into a retail store clearly recognize that a salesperson is still a salesperson regardless of whether he calls himself an advisor, much of the financial services benefits from a lack of clarity as to whether a particular financial advisor has the characteristics of a salesperson – or a fiduciary.   According to the Wall Street Journal, there is “widespread confusion among investors about advisor’s titles, responsibilities, and legal duties to clients.”   The Journal noted that “Many brokers now call themselves advisors, causing the client to believe that the broker is always looking out for the clients best interest…the broker is also allowed to promote inferior mutual funds that generously compensate the broker for selling them, rather than what‘s best for the investor.”[9]

      The AARP, which represents millions of senior Americans in great need of unbiased investment advice, recently wrote a letter to the Securities and Exchange Commission on the issue of investor confusion:  “Investors across the country trust their savings and retirements to the advice of brokers. Yet, under current rules, brokers are free to sell products that are less advantageous to investors in order to make more money for themselves, without the clients ever knowing.  Investors are routinely lured into making the mistake that a broker is acting as a trusted adviser when that broker’s representative calls himself a financial adviser and offers services such as retirement planning or investment planning.”[10]

     And then there are ‘advisory fees”, which are usually between one and one and a half percent of assets under management.  If mutual fund managers face long odds of outperforming a low-cost basket of index funds, it should surprise no one that investment advisors face even longer odds of doing so.  As a result of greater ‘fee-consciousness” among investors, advisory fees are likely to come under severe pressure as investors realize that most advisors cannot outperform a low-cost index fund portfolio.  Instead, advisors will have to justify their fees on the basis of the real value they can add in the areas of tax, retirement, education, and general financial planning.  It has been estimated that expertise in these areas can add as much as three percent in annual net after-tax investment returns to the investor. [11] In the author’s opinion, this is where true investment-related value can be provided to clients.

     The issues that impact individual investors affect 410(k) retirement plan participants even more so, because 401(k) participants are often subject to a limited menu of high-fee mutual funds.   Sellers of 401(k) plans rarely discuss investment fees before the employer actually purchases the plan, because, under current law, plan sellers are only required to disclose investment fees during enrollment, after employers have purchased the plan, making it difficult for participants and employers to effectively “comparison shop”.   Worse, one General Accounting Office study showed that 80% of plan participants were unaware that they were paying any fees![12]

      Business owners also need to be aware that sellers of 401(k) plans often require mutual fund companies to pay to play”, in order to be included in the choice of funds that will comprise the 401(k) plan.  Because Vanguard does not pay fees to third parties to be included in 401(k) plans, Vanguard funds are often excluded from many 401(k) plans.[13]  Before signing up for a 401(k) plan, employers should require a full accounting of all investment fees, including management fees, expense ratios, commissions and 12b-1 fees.  They should also ensure they have access to the broadest possible selection of low-cost index funds, which are usually obtainable in an “open architecture” investment menu.

     No less an authority on investments – and the realities of the financial industry - than Warren Buffett had this to say on the subject of index funds:  “Seriously, costs matter.  Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the results delivered by the great majority of investment professionals.” [14] (Italics added.)


Madrone Investment Advisory, LLC is a flat-fee, independent California registered investment advisor.  All financial and investment advice is provided under a fiduciary standard.  Madrone Investment Advisory has no affiliation or referral arrangements with any broker-dealers, insurance companies, or any other parties..

Copyright © Michael H. Zaidlin 2014.  All rights reserved.  No part of this document may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying or recording, or by any information storage and retrieval system without written permission from the author.

Disclaimer and Warning:

The information contained in this article is solely for general informational and educational purposes only and does not constitute investment, estate planning, legal or tax advice or a solicitation of sales or services.  The author has no liability or responsibility for any loss caused, or alleged to be caused, by the information or lack of information in this article.  The information presented is believed to be accurate at the time of publication, (February 2014) but cannot be relied upon without consulting with the appropriate tax specialist, financial professional, or attorney.  For retirement planning, financial, or investment advice related to your particular situation, please consult your tax specialist or investment\ financial professional.  The author shall have no liability or responsibility, directly or indirectly, for any loss of damage caused, or alleged to be caused by any information or lack of information contained herein.

All investments, including stocks, bonds, real estate, commodities or other investments, carry risk, including risk of total loss of principal,  This risk is true not only for actively-managed mutual funds, but for index-based funds as well.  Shares of an investment, when sold, may be worth more or less than what the shares were purchased for.  In particular, even when shares are sold for more than they were purchased for, the effects of inflation may mean the investment is actually worth less in “real “terms.  Investing in any mutual fund or exchange traded fund, whether index-based or actively managed, is no guarantee that an investor will make a profit. Investing always carries risk, including the risk of total and complete loss of the investor’s principal investment. All presumed future annual rates of return mentioned in this article are for illustrative purposes only, and cannot be relied upon.  

DISCLAIMER OF TAX ADVICE: This presentation and any attachments are solely intended to communicate general information for discussion purposes only.  The information herein is not intended to constitute written tax advice within the meaning of IRS Circular 230 §10.37, and is not intended to be relied on, nor can it be used, for that or for any other purpos

[1]  The Globe and Mail, “The Tyranny of Fees: How Cost Kill Investment Returns”, interview with John C. Bogle, April 26, 2013

[2] Robert H. Jeffrey and Robert D. Arnott, “Is your alpha big enough to cover it’s taxes?”, Journal of Portfolio Management, (Spring 1993), pp. 15-25

[3] Allan Roth, “Mutual Fund Fees Jump 5 Percent.” Aug. 17, 2009; www.marketwatch.com

[4] /www.dol.gov/ebsa/publications/401k_employee.html, ,accessed on September 29, 2014

[5] Paul Samuelson, “Challenge to Judgment”, Journal of Portfolio Management”, Fall 1974

[6] Jack C.Bogle, “Common Sense on Mutual Funds”, pg. 209 (John Wiley & Sons, 2010)

[7] Bogle, supra. Pg. 207

[9] Suzanne Barlyn, “What’s No. 1 for Brokers?” Wall Street Journal, pg. R3, Dec 6, 2010, citing Barbara Roper, Director, Consumer Federation of America.,

[10] Letter from David Certner, Legislative Counsel, Legislative Policy Director,  American Association of Retired Persons, to Elizabeth M. Murphy,  Securities and Exchange Commission, File #4-606, Aug. 30, 2010

[11]Francis M. Kinniry Jr., CFA, Colleen M. Jaconetti, Michael A. DiJoseph, CFA, and Yan Zilbering “Putting a value on your value: Quantifying Vanguard Advisor's Alpha”, www.pressroom.vanguard.com, March 2014, accessed on September 26, 2014.

[12]  ICMA-RC “GAO Study Advocates Greater 401(k) Fee Disclosure”, Dec. 2006, http://www.icmarc.org

[13] Edward Siedle, “Secrets of the 401(k) Industry”, n.d. http://www.benchmark.com

[14] Warren E. Buffet, “Chairman’s Letter”, Berkshire Hathaway Inc., Annual Report, 1996.