Investment fees are the bane of performance. Fees detract from an investor’s gross returns, eroding performance over time. The effect compounds; account values lowered by fees then produce lower gross returns in subsequent years. It is essential to include fees and all other costs in the decision-making process.
Our obsession with fees becomes unhealthy when fees become the primary determinant in the investment decision, as opposed to being where they belong, as a consideration.
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The Investment Decision-Making Realm
Investments should always be linked to a purpose. We all tend to have goals and a vision for our financial futures. It is our goals and vision, coupled with our assets and ability to save, that should drive our investment decisions. Investments need to be selected first for their ability to help support our goals and vision.
Aligning assets and goals produces investment-class level allocations, through an asset allocation, portfolio model, or whatever technique you are using to determine the proper asset mix given your resources and constraints.
At this level, fees do not yet enter into the calculation. At this level, you are determining that X percent of your portfolio should be in a specific asset class; which investments in that class, and their potential fees, are decided later in the process.
Investment Tax Structure
The tax structure of your portfolio is considered in conjunction with your overall portfolio design. Some of your assets, perhaps most of your assets, will be eligible for tax-deferred status in retirement or education accounts.
The extent to which you use tax-deferred accounts, and which specific accounts, depends on your own individual situation. Your status as self-employed or employed, or even not employed, along with your income, determine what tax advantaged vehicle you have available.
Work sponsored retirement plans have special considerations. Matching often trumps fees. You might find a similar specific investment with a lower fee outside of your plan, but it would be foolhardy to forgo something like a 50 percent match to save a tenth of a point in fees.
When considering what type of account to use, we’re not yet to the level of a specific investment, and hence not yet considering fees. At the tax structure level, we determine how much to allocate to IRAs, or Roth IRAs, or qualified plans, and what we will hold in non-qualified investment accounts, which bring us no immediate tax advantage.
Investment Fee Considerations
Fees are important; they are a component of the investment decision. It is important to select the right class of investments and the best type of account to hold the investment, and then to make a selection of specific investments within those constraints. And that selection process includes consideration of fees.
This is their proper place: a consideration, given what we should own, and how we should own it. Once we are down to the individual investment selection within this narrow sphere, then it is time to bring fees into the equation.
Fees, along with other characteristics, will determine which investments you place in which accounts.
If you have an investment that generates ongoing income, and one that builds tax-deferred appreciation, you might consider, for example, putting the one that generates the income into one of your tax-deferred accounts and the one that naturally shelters you from tax via appreciation in a non-qualified account, thus minimizing your current tax burden.
Naturally do this only if the move makes sense otherwise.
The lowest fee investment is not always the best choice investment. It may be, but it also may not. There are other considerations. Let’s consider an example.
Let’s say you have determined that a large cap stock fund is the appropriate investment for an amount of funds earmarked for a specific goal. Let’s also say this investment will be held in a non-qualified account because you anticipate needing the funds before retirement age.
You find a few funds you like. Two of your favorites have nearly identical performance, but one has a slight fee advantage. Seems like that’s the way to go, doesn’t it? But then you notice that the one with the lower fees has a bit higher turnover for some reason.
Now you have to consider if the slight fee advantage will be offset by higher tax costs due to the higher turnover in the lower fee fund. Even in index funds, which by their nature should have low turnover, this should be examined. The fee should be considered in conjunction with other factors to determine which provides the greatest net return to you, the investor.
It will generally work out to be one of the investments with low fees, not always the one with the lowest fees. Our unhealthy obsession with fees can cost us investment performance if we place the consideration of fees above other factors.
Additional Considerations
In addition to considering fees of specific investments in comparison to others, we can manage our long-term costs through other means.
Using a buy and hold strategy can help keep transaction costs to a minimum. Investors who make frequent trades tend to underperform investors who hold investments and make fewer transactions. The primary reason the frequent traders underperform the holders is fees. Avoid creating unnecessary fees by chasing investment returns.
You can avoid only the fees you are aware of. It is essential to know your investments by doing the necessary research. You need all the information to be able to make an informed decision.
When in doubt ask. There are a lot of resources out there, and investments come out of big businesses with service and investment teams who should be able to answer investor questions. Personally, if I have trouble finding the necessary information, I consider that a red flag. There is no reason for lack of information.
The Bottom Line on Investment Fees
Investment fees are important as a consideration. There is a danger in using investment fees as a primary determinant of investment selection. What we keep is based first on the investments we select — and that’s at the level of investment class. How much you have in what class will have a far greater effect on performance that will save a quarter or half point on fees.
The second consideration is how we own investments, the type of accounts we use to hold them. Taxes are potentially a far more significant drain on investment returns than fees could ever be.
Once you’re down to individual investment selection, fees come into play as one of many factors. They are an important factor, and one that will work with other factors to determine what you get to keep from your investment returns. And that’s your real bottom line, what matters is what you keep. The cheapest is not always the best.
