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Are you paying too much to invest in the stock market?

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For a few years now, I have been telling everyone I know that investing in the stock market is a great way to grow your wealth.  When I started my first full time job after college, I invested in the mutual funds under the company’s 401(k) plan. After a couple of years, I had some money left over and started investing in a taxable brokerage account as well. I think a good way to start investing is to go with low fee Index Funds. You can build a stable foundation and then branch out on dividend stocks, speculative stocks, bonds, real estate, and other investments later.

It can be very daunting to start investing in the stock market. When I first started investing, I didn’t know what I was doing at all. I just picked the funds that looked like it was doing well recently. Now that I’m older, I know this is the wrong way to go about it. When you buy funds that performed well last year, you are probably late to the party. The right way to start investing is to begin with low fee mutual funds/ETF from a solid company like Vanguard and Fidelity. But as a beginner, how do you know what is low fee?

Loads

Loads are fees that can be charged when you buy or sell a mutual fund. It’s a percentage of the amount you are buying or selling.

  • Front-load fund. You pay a percentage of your purchase when you buy the mutual fund.
  • Back-load fund. You pay a percentage when you sell the mutual fund.
  • Constant-load fund. You pay out fees at a regular interval.
  • No-load fund. You don’t pay a fee.

It’s pretty simple when we list them out – a regular investor should stick with no-load funds. The only encounter I had with loaded funds was when I talked to a financial adviser at my credit union. I’m sure he was making a nice commission from these funds because he was pushing them pretty hard.

Expense ratio

Definition of Expense Ratio from Investopedia.com

A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual calculation, where a fund’s operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund’s assets and lower the return to a fund’s investors.

Basically, this is how much fee you are paying annually to invest in a mutual fund.

Rule of thumb

I read somewhere that investors shouldn’t buy a fund that charges more than 1.5% expense ratio. My rule of thumb is to keep the expense ratio under 1%. However, even 1% is expensive. It doesn’t sound like much, but if you have $100,000 invested, you’ll pay $1,000 per year in fee. That’s a lot of money and it will eat into your return on investment (ROI.)

Some funds are more expensive than others. I made a small table to help beginners. I’m sure it’s not complete and if you think I should add something, let me know.

Lower Expense Ratio Higher Expense Ratio
Large Cap (NASDAQ) Small Cap (Russell 2000)
Passively Managed Funds (Index) Actively Managed Funds
US Funds International Funds
Developed Countries Emerging Markets

If you want to invest in international market or small cap, you’ll be paying more fees. It’s more work to run these funds.

Are you paying a lot of fees?

How can you tell if you are paying a lot of fees? That’s hard to answer, but here is what I do. I check the fund symbol on Yahoo! Finance and go to the Profile tab. Let’s take a look at MFS Emerging Markets Equity A. (This A means it is a front-load fund.)

Fees & Expenses MEMAX Category Avg
Annual Report Expense Ratio (net): 1.66% 1.58%
Prospectus Net Expense Ratio: 1.71% N/A
Prospectus Gross Expense Ratio: 1.72% N/A
Max 12b1 Fee: 0.25% N/A
Max Front End Sales Load: 5.75% 5.41%
Max Deferred Sales Load: N/A 1.83%
3 Yr Expense Projection*: 1,085 817
5 Yr Expense Projection*: 1,454 1,317
10 Yr Expense Projection*: 2,488 2,735
* Per $10,000 invested

We can see that the expense ratio is quite high at 1.66%. This is just a tad higher than the category average, but I don’t think we should pay anywhere close to the average. I like to keep the expense ratio at less than half of the category average, but it’s your decision. Take a look at the 3 years expense projection. That’s over 10% of the initial investment of $10,000. The fund would have to do very well for the investor to make a profit.

Let’s compare MEMAX to the Vanguard Emerging Mkts Stock Idx Adm, VEMAX. This is the Admiral share and you need to invest at least $10,000. Alternatively, you can go with VWO, an ETF.

Fees & Expenses MEMAX VEMAX
Annual Report Expense Ratio (net): 1.66% 0.20%
Prospectus Net Expense Ratio: 1.71% 0.20%
Prospectus Gross Expense Ratio: 1.72% 0.20%
Max 12b1 Fee: 0.25% N/A
Max Front End Sales Load: 5.75% N/A
Max Deferred Sales Load: N/A N/A
3 Yr Expense Projection*: 1,085 64
5 Yr Expense Projection*: 1,454 113
10 Yr Expense Projection*: 2,488 255

Could MEMAX’s performance justify the much higher fee?

Here is the year to date chart comparing MEMAX to VEMAX. Click through to see larger chart.

are you paying too much to invest in the stock market?

We can see that MEMAX is doing a bit better than VEMAX so far in 2012.

However, the fee really eats into the ROI over the long term. VEMAX is doing much better when we extend the chart out to 6 years.

are you paying too much to invest in mutual fund ETF

I wouldn’t mind paying the fee if these actively managed funds can blow the door off the Vanguard Index Funds, but most of them can’t compete with Vanguard over the long haul. The high fee just goes toward the fund manager’s new yacht.

12b1 Fee

Did you notice this fee in the tables above? This is another fee and you probably should avoid the funds with any 12b1 fee.

Go with Index Funds

This is why I think most beginning investors should start with low fee index funds. Have you checked how much you are paying to invest in the stock market lately? For me, seeing 0.8% didn’t make a big impact. It’s when I found out through Personal Capital (free) that I’m paying $1754.91 in fee that I woke up and started the 401(k) rollover process.

For the research on this article, I picked MEMAX because MFS was the crappy fund family the aforementioned “financial adviser” sold me when I first started investing.

Sign up with Personal Capital through this link.

Disclosure: I am not a financial adviser and I’m writing this from my personal experience. You should do your own research and/or consult a professional before investing in the stock market. I am NOT an expert. I have no position in MEMAX and VEMAX. I have position in VWO. I may get a referral fee if you sign up with Personal Capital.

 

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{ 23 comments… add one }
  • Moneycone October 26, 2012, 4:56 am

    Informational post Joe! Fees eat into your gains. Go with low cost funds – that is the only thing an investor can control, not the returns.

    • retirebyforty October 26, 2012, 9:32 am

      Most of our investments are in low cost funds. My mission is to move everything over by the end of this year.

  • NoTrustFund October 26, 2012, 6:23 am

    Even advanced investors would do well to stick with index funds. As someone who keeps all my money at vanguard, the fees other funds charge always come as a shock to me. Vanguard even lowers their fees as you have more money and can start using their admiral shares. Many funds end up costing less than one half of one percent! Load and high fee funds have to REALLY outperform to make up for that difference!

    • retirebyforty October 26, 2012, 9:34 am

      The majority of my investments are in Vanguard funds. I have only 3 non Vanguard funds left and will move them over to Vanguard by the end of the year. The fee really eat into your ROI over the years…

  • Jeremiah October 26, 2012, 7:40 am

    Solid post on an important topic.

    Question: how are fees calculated into the graphs that you show? Are those returns after fees (and dividends, etc.)?

    • retirebyforty October 26, 2012, 9:39 am

      I’m pretty sure the charts are after fees, splits, and dividends.

  • RichUncle EL October 26, 2012, 8:42 am

    Nice post I always check the fees for any new investment I want to buy. Yes we are getting spoiled now with the index funds being so cheap as compared to higher costing funds. I guess we have to keep the power in our hands and invest only in anything that is less than .50% in fees and slowly and systematically remove all those higher priced investing options.

    • retirebyforty October 28, 2012, 8:53 am

      0.64% is my new threshold. 🙂 I have one fund that I’d like to keep a while longer.

  • W at Off-Road Finance October 26, 2012, 10:13 am

    In the US you’re crazy not to use the SPY ETF for broader market exposure. It has tracked essentially perfectly – perhaps 0.1% of slippage per year.

  • SavvyFinancialLatina October 26, 2012, 12:05 pm

    Thanks for the post!

    I actually weeded out two funds with high fees this week. I haven’t sold them yet. There’s only $300 in each one, and I’m going to wait to get a higher price, but I’m not going to contribute to them anymore.

    My 401K fees range between .46% and .84%. .46% is a bond fund. I want to eliminate the .84% fee fund.

    • retirebyforty October 28, 2012, 8:54 am

      Great job! It doesn’t seem like a big deal when you have $300 in the fund, but the fee will add up as you increase your investments.

  • Brick By Brick Investing | Marvin October 26, 2012, 12:36 pm

    Great post, fees definitely eat into your gains over time. I would always advise that individuals look into educating themselves on how to value companies and invest in individual stocks. This will completely eliminate fees of any kind.

    • retirebyforty October 28, 2012, 8:56 am

      It’s harder to rebalance and you have to pay the transaction fee. If you have time and knowledge, then sure. 🙂

  • krantcents October 26, 2012, 1:21 pm

    As I get older, I want to simplify my life which includes investing. I always use low cost index and sector funds. I also have a few stocks and ETFs. I am starting to reduce the number of funds/other as I sell and reinvest.

    • retirebyforty October 28, 2012, 8:57 am

      I’m trying to simplify too. That’s why I’m rolling over and consolidating my investments. We’re too busy to pay close attention to each stocks.

  • Leigh October 26, 2012, 8:45 pm

    Hmmm, let me do the math. My current portfolio is costing about $130 per year. That’s all Vanguard index funds. I have an Admiral Shares fund in my taxable account and my Roth IRA funds will be converted to Admiral Shares hopefully next year, but the money in my 401(k) is a huge chunk and I only have access to Investor Shares there…having that money in an account where I could get access to Admiral Share could cut my expenses to under $100! I guess I should be lucky that I have access to great Vanguard index funds at least!

    • retirebyforty October 28, 2012, 8:58 am

      Wow, that’s great! My goal is under $500 after I consolidate. We’ll see if I can do it.

  • thestarvingartistcanada October 27, 2012, 4:34 pm

    I’m NOT a fan of index funds… There are far too many losers in the basket.

    I have almost eliminated all my holdings except for the ones I use for short term trades, or for writing naked puts (so I never own them). So if the market goes up, I make money. If the market goes nowhere, I make money. If the market goes down, I make money! If the market tanks (more than 6% drop in a month) then I’ll close my positions for a small loss.

    • retirebyforty October 28, 2012, 8:59 am

      Sounds complicated. 🙂

  • Edward Antrobus October 28, 2012, 3:38 pm

    I mostly try to stick with lower fees, but my thought on the matter is: if one fund has fees .4 percentage points higher, but averages .6 percentage points higher return, I’m coming out ahead.

    • retirebyforty October 29, 2012, 10:27 am

      The problem is that it’s quite difficult to come out ahead consistently. That’s why index funds are usually the better choice for the individual investors.

  • Chris October 28, 2012, 7:17 pm

    If my employer’s 401k plan would allow for individual stocks, I’d do that in a heartbeat. Granted my ROI has still kept about 3% or so above the fees I pay in fees, but that’s nothing in comparison to my ability to pay a mere $8 for up to 1,000 shares of any stock that I purchase in my Fidelity account (and that’s over 20% both this year and last year).
    Can I purchase the funds also? Yes, but I’d rather pick it myself lately.
    After having to be limited in 401k funds for 10+ years, I compared my own stock picking for those years to compare against where my portfolio ended by the end of the year.
    I didn’t try managing it on my own on a whim. I did however put together a make-shift portfolio using Quicken (and for the past couple of years Google Finance’s portfolio manager). It might be in one’s best interest to try their hand at something like that, after all, it surely doesn’t cost you a penny to be right/wrong with one of those portfolio’s.

    • retirebyforty October 29, 2012, 10:34 am

      If you can consistently beat the index, then that’s awesome.

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