Expenses: A Hidden Drag On Performance

Contributed by Doug Walters , David Lemire , Max Berkovich , Eh Ka Paw

The best things in life may be free, but investments generally are not. You may not always see their cost, but they are there, quietly dragging on your performance. For this reason, we include “expenses” in our evidence-based guiding principles. Knowing what to look for and ensuring you get value for that cost is essential to successful long-term investing.

One evening, I attended an event where attendees went around the room, introducing themselves and their businesses. One participant said she worked as a financial advisor, and the great thing about the firm was that they “don’t charge their clients anything.” Sounds like a great business model… give your services away for free! But of course, they are charging their clients, potentially a lot, and likely through hidden fund expenses… and probably mutual funds issued by their own company. Sounds like an egregious conflict of interest to me.

The fees can come in many forms. Brokers, for example, might sell you funds with a front-end “sales load” (a fee paid upfront to purchase the shares). These can be over 5%. The most basic fees are those internal fees that cover management and administration (the fund providers do have to get paid, after all). These are often referred to in terms of an “expense ratio.” You can look up any fund online and find its expense ratio. This tells you how much of your investment will be paid out in fees each year. A 1% expense ratio on a $10,000 investment equates to $100 a year. That is a significant drag on performance that the investment manager needs to overcome.

We typically use exchange-traded funds (ETFs) as their expense ratios tend to be lower than the mutual fund peers (although that gap is shrinking). For a basic fund like Vanguard’s S&P 500 ETF (VOO), the expense ratio is currently just 3 basis points (or .03%).

But, investors should not seek just to minimize fees. Instead, it is important to be “fee aware.” If you know you want exposure to something basic like the S&P 500, then the cheaper options from reputable fund providers may do the trick. But if you want something more sophisticated, more work must be done. We practice factor investing as Strategic. So, when we want exposure to, say, a value fund, we will not just look at fees but also whether the funds are giving us the right type of value exposure and whether or not any extra expense we may pay for that access is giving us the extra performance we are seeking. Performance after fees is what matters.

Vanguard¹ estimates the average value of moving to lower-cost funds to be 30 basis points per year. That is a meaningful number but underestimates some of the worst cases we’ve seen come through our doors, with expense ratios in excess of 1.5% and private investments with outrageous “2 and 20²” agreements that have not paid off.

Avoiding a few tenths of a percent of performance drag may not seem like much, but it adds up over time. When taken in combination with the potential benefits of our other guiding principles, it could mean the difference between achieving your great life vision… and not.

Previous articles on our guiding principles can be found here:

• Guiding Overview: Unveiling the Evidence
• Patience: The Foundation of Investing Success
• Diversification: Winning Even if It Doesn’t Feel Like It
• Factors: Systematically Advantage Your Portfolio
• Rebalancing: It Pays to be Opportunistic
• Expenses: A Hidden Drag On Performance
• Taxes (upcoming)
• Behavior (upcoming)

1. “Putting a Value on Your Advisor: Quantifying Vanguard’s Advisor Alpha®,” Vanguard, July 2022

2. We did not dive into the world of alternatives here. “2 and 20” is a common hedge fund expense structure where they charge 2% (ie. 200 basis points) and the also take 20% of the profits. That creates a huge performance hurdle to clear which is why so many alternative investments prove not to be worth the cost.