The Irrelevance of Fees (Expense Ratios) in your Investment Portfolio

The most common question prospective clients ask about our investment philosophy involves the fees charged by the funds we use: “Do you recommend active or passive funds? What about the fees?” The low-fee-fetish on many physician finance sites is good clickbait but I believe it can be harmful if not kept in perspective. Placing such a heavy emphasis on low-fee funds (such as at Vanguard) can lead to a false sense of security. “My funds all have low-expense ratios! I’m 95% of the way to investment success!” In reality, I believe the fund expense ratios – for any investor – account for less than 5% of results.

What are these “expense ratios” I’m referring to? These are the annual fees that all mutual funds and ETFs charge for the cost of doing business. A fund doesn’t just operate on a free cloud – it must have advertising, managers, research expenses, and other operating costs. These costs are paid by the fund itself and, so, reduce the returns of the fund.

Of course, fees matter. Let’s say (all other costs being equal) that Fund A’s managers cost Fund A .1% of fund assets and Fund B’s managers cost Fund B .5% of fund assets, do you want to own Fund A or Fund B? If you answered Fund A, what if I next told you that Fund A’s managers cost less because they were just out of training and Fund B’s managers had a long and successful track record? Decisions must be based on much more than fees.

Which is where funds that are passively managed come in. Passive funds are managed by computers, designed to replicate and track an index, so their fees are typically much lower than the “actively managed” funds above. Investors, fund managers, and financial advisors alike continue to have heated debates over which method is preferable. Passive funds have become immensely popular in the last 40 years, but that may be changing.

So where do we stand in the active (higher fees) v. passive (lower fees) debate? We are agnostic. Our client goal is optimum growth of long-term wealth and I just don’t happen to believe that fund fees are going to have much effect. We currently use passive funds not because we believe they will give our clients an edge, but because physicians approach us with the low fee = best investment mindset and, so far, it’s been simply easier not to argue that philosophy. Maybe this article will change that J.

Last month, I listed three traits of portfolios that you should avoid.

  1. You do not have a well-diversified equity portfolio Our clients are successful long-term equity investors whose optimal long-term returns result from owning a diversified basket of equities, not from a bet on a particular sector. Take the last bear market in 2008. Many investors owned far too much real estate in their portfolios and they still haven’t recovered. Those who allocated only a small part of their portfolios to real estate and stuck with a well-diversified equity portfolio, on the other hand, had no long-term adverse effects and have benefited greatly by staying in the market.
  2. You are a stock-picker The most common example of stock picking is employees who have a large part of their portfolio in employer stocks. If you are counting on employer stock to support you in retirement, you are making a dangerous bet. If you must own your employer’s stock, let it occupy no more than 10% of your portfolio. A diversified basket of quality mutual funds and ETFs ensures that you will never have enough of any one stock to be permanently hurt.
  3. You invest for the short term You may have a well-diversified portfolio that is invested in equity funds, but, without a plan in place, you’ll be more susceptible to panic when the market nosedives, leading to irrational behavior such as a sudden fondness for bond funds. The short term market is volatile and unpredictable – a real gamble – but returns smooth into an upward trend line over the long term. How do you know how much you should keep liquid in the short term and how much you can invest for the long term? You follow a personal financial plan.

Did you notice something missing in my list? Of course, it’s high fees. If you avoid the above mistakes, expense ratios will be fairly irrelevant.

I’ve left out the biggest reason that I believe fees are irrelevant for most investors. Let’s say you’ve designed a well-diversified portfolio with super-low fees. You’ve done pretty well for the last 8 or 9 years, which I believe describes many readers of WCI and other physician financial blogs.

Your low-fee funds won’t contribute anything to your investment success if you panic and do something stupid in the next correction, bear market, or “crystal ball” moment. A focus on fees without good investment behavior while following proper principles, is like thinking you can lose weight by only counting calories. You won’t get very far toward your goal!

“So you’re telling me it’s not a problem to buy high-cost funds?” Absolutely not. I believe you should instead understand how to prioritize your investment choices:

  • Never put any money in the stock market that you will need in the next five years. How do you know? You base what you can invest on a financial plan, whether DIY or by working with a professional.
  • Since you’re investing for the long term, you should optimize growth with a properly-diversified equity portfolio, rebalanced annually.
  • Diversify your risk with mutual funds and ETFs, not individual stocks (including employer stock). You will never be able to have enough information to consistently choose stocks that will beat the market.
  • All things being equal after you’ve taken the above steps, then buy funds with reasonable fees. There are many excellent funds to choose from with fees under 1%. You don’t need to choose the cheapest index fund possible; just recognize that, in the long run, the fees on quality funds in a properly diversified and managed portfolio will have little impact on your long-term returns.

Want some proof? I asked Michelle to back-test our prior “actively-managed” portfolios, comparing them to the passive portfolios we currently use for her vlog for this month. (Of course, we follow all of the above rules!) See what she found out – you may be surprised.

If you’d like to connect the dots and stop wondering if you’re making the best financial decisions for your family, schedule a free initial consult! There is absolutely no obligation and we’ll do our best to answer all of your questions.

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