Why lower management fees for your investments do matter and why many mutual fund companies should be out of business soon

The other day, a friend of mine was slightly amused after I bombarded him with reasons why he should always check management fees before selecting a Mutual Fund or (even better) an ETF.

His words: “C’mon, what difference does a management fee of 1.5% for my mutual fund vs. a fee of 0.5% for a good ETF make?  After all, I am investing for the long run—for my retirement in 20+ years.

Good point.  I totally agreed with his investment horizon, but my stomach churned on the statement that 1% sounds so small and would not make a difference.

Let me explain why my stomach felt so weird.

Ever heard of Fidelity?  No, not the antonym of infidelity.  I mean that big global fund house with an extraordinary business model: The average Fidelity retirement account in the US had US$89,300 in it in 2013 and Fidelity’s average management fee was 1.01% of assets, according to Advisor Investments.  The average American customer—then—paid Fidelity US$901 for its services last year.

I  dare say that not even Apple earns that much annual revenue from each customer.

But there’s something incredible about this success.  No Fidelity customer actually received a bill for US$901 last year.  No customer wrote a cheque for that amount.  No one put US$901 on their credit card or wired that much to Fidelity through PayPal.  No one received a bill from Fidelity in the same way they would receive a phone bill from your dear Telecom Service Provider.

This isn’t picking on Fidelity—it’s just how the entire money management industry works.  Most mutual-fund and unit trust revenue is received based on a simple calculation: At the end of each day, an annual management fee is divided by 365 and multiplied by the amount of assets under management.  That amount—it’s a daily fee—is then deducted from the fund.  It’s automatic.  Customers are charged (big) fees for each day they invest in their funds, but no one pays—or even sees—an actual bill.

There’s nothing tricky or dishonest about this.  Such funds are upfront about all of their fees (and there are many more) and are required to clearly disclose annual management fees in annual investor reports (you do read them, right?).

What a great business, where customers can pay literally tens of thousands of dollars per year and not even realize it.  Since the  fees are disclosed as a percentage of assets—rather than a dollar amount—they’re harder for lay investors to put into context.  And as they’re deducted automatically—rather than billed directly—they’re out of sight, out of mind.

Imagine this: You’ve a $10,000 account placed in a fund for 25 years growing at 5.4% on average annually (without dividends) while being charged 1% a year in fees.  Every year, and independent of the Fund Manager’s actual performance!

How much do you think you’ll be charged in total?

Turns out, you’d be paying $8,000 in fees.  Think about that for a minute.  $8,000 in total fees for an initial investment of $10,000 which grew at only 5.4% a year!  Does that sound right?

Try it out: http://www.dinkytown.net/java/InvestmentReturn.html

That seemingly small 1% annual fee figure could easily blind people (like my friend) to the real effect of fees.  The trouble would compound when fees are much higher than 1%, which often is the case in Singapore.

But what if this were different?  What if unit trusts and mutual funds and money managers had to charge fees (like all other businesses) in the form of a monthly bill sent directly to customers?

I could guarantee one thing: there would be an investor revolution.

Imagine if every month, while paying your housing loan/power bill/cell phone bill, you had to write a cheque to your mutual fund manager for, say $200, and perhaps another check to a custodian bank for, maybe $25?

You would instantly become keenly aware of fees.  You’d probably become obsessed with them.  You wouldn’t put up with a high-fee investment manager who chronically underperforms his benchmark.  You’d shop around to see who offered the lowest costs.

Picture yourself in the monthly cheque writing scenario, and ask yourself if you would pay your Fund Manager directly for these services. If the answer is yes, keep your Mutual Funds; if the answer is no, you have your next action plan.

Unfortunately, very little of those action plans are happening right now.

Until investors actually have to write a cheque themselves, they are going to be unaware of the fees they’re paying.  And that promises more bad investing decisions and a wealth transfer—from workers to bankers—based solely on a lack of understanding.

Is it asking too much to bring a little light to these fees by making customers pay them directly?  Still, it would be naïve to expect any fund company to do this, without being regulated to do so—it would mean additional efforts and costs which might eat into their nice bonuses short term and reduce revenues mid term.

Nevertheless, good news: You always have a choice.  If the industry won’t change, then at least you (the customer) can change your behaviour when it comes to buying funds or unit trusts: You just need to be acutely aware of fees, your tendency of Mental Accounting, and the Relative Dollar Bias.

Then compare them to the fees you are charged on ETFs (Some broad-based Vanguard ETFs charge as low as 0.03% p.a. = 50 times less than the average manages fund with 1.5% p.a.).  Next, recall that only a vast minority of Fund Managers beat the index over a longer period of time anyhow.  And then, realize that it is about time for some “In-Fidelity” and you stop investing further into Mutual Funds and divert your hard earned money into ETF-investments.

FEE, such a tiny word with a cutesy sound, which powerfully is the single biggest determinant of success or failure for many investors.