Fund Fees: Slash Them Early

It’s sometimes hard to impress upon people the impact of fund fees. In a recent Wall Street Journal article, however, I saw the perfect example sitting about halfway through the piece.

The article isn’t about fund fees directly. Rather, it is a good recounting of how investors are dumping active mutual funds for cheaper passive strategies, partly over fund fees but also over a general feeling of discontent regarding performance.

I can’t say I blame them. Lots of pro stock pickers warned against investing in 2012. Yet the S&P 500 Index finished the year up 16% (total return). Oops.

I found more interesting the quote from Kevin Olson, a 26-year-old from Iowa who say he and his wife just put $5,000 into the Vanguard Total Stock Market Fund (VTI). I love VTI, but there are of course reasonable alternatives, such as Schwab’s U.S. Broad Market ETF (SCHB).

Olson is an engineer. No surprise there. Money pros know that engineers tend to be the most judicious and least emotional of their clients. All spreadsheets and software and realism about numbers. They also tend to actually retire on time and well.

But the really telling part is that he’s young and putting aside a nice chunk of change. I have no idea if that’s their entire portfolio or just the amount they decided to move now, or what portion of his or her salaries that might be (nor does it matter).

But $5,000 is impressive. Most young folks would have trouble figuring out where to find $1,000, much less $5,000, to put away right now.

And now is when it matters. Here’s the fund fees picture for Olson and his wife:

• Invests $5,000 and nothing else (doubtful, but let’s assume it for this exercise)
• VTI charges him 0.06% (according to Vanguard)
• The market returns 7% annually
• He stays invested 20 years

Result: $19,118

Total expenses, including opportunity cost: $231

I won’t run the whole thing again for more expensive funds in VTI’s class, but compare that to the category average of 0.30%, and the final number is lower ($18,220) and expenses explode to $1,128.

Interesting enough, but what’s really key here is the other number in this story: 26. Olson won’t be retiring in 20 years flat. He’ll be mid-career.

Put another 10 years on that investment at 7% with the same, low fund fees in VTI, and the total runs to $37,382, while expenses track along at $679.

The true cost of Wall Street fund fees

In the more expensive versions of a total market fund, his return would be lower ($34,781) and fees would rise to $3,281. The difference in the fees is what’s astounding, a 383% jump in cost for the same service.

Put another way, using VTI means Olson gets 30 years of investment management at the cost of a desktop computer today.

Just for laughs, let’s run that against the typical active mutual fund fee of 1.27%. As you might have figured, it’s much, much more costly. Olson’s $5,000 turns into $25,939 — an “okay” result.

Meanwhile, total expenses for the active fund over 30 years come to $12,122.  The gap in performance is explained not by poor markets but by fund fees. The active fund manager has kept 32% of Olson’s potential return.

Nice work if you can get it, right? Simply put, your aim as a retirement investor should be to deprive Wall Street of the high fund fees gravy train.