When you’re investing your money for the long run, you probably think the average return your investments earn is what matters most. After all, if you average 7% a year over 30 years, you’re in good shape, right?
Not necessarily.
One of the “silent killers” of investment success is the accumulation of management fees. These may seem small each year, but over decades they can shave a surprisingly large amount off your final portfolio value. In this article I’ll explain why keeping fees low is so important, walk through a clear numerical example, and cover four key topics:
- How most mutual funds underperform their benchmarks when fees are taken into account
- How small differences in fees can have a large compounding impact on portfolios
- What investment vehicles typically have the lowest fees (ETFs vs mutual funds vs hedge funds)
- Industry trends towards lower fees
Why minimizing management fees matters
Fees matter because they are deducted from your investment returns — and once that happens, there is less money compounding in your favour. Even a seemingly modest extra fee of 0.50% per year can make a big difference over 20-30 years.
A 0.50% difference in fees over 20 years translates to $10,000 more dollars in your retirement portfolio for every $100,000 you initially invested. That’s 10% more money for you to spend just from limiting management fees!
A specific example
Let’s say two portfolios both earn a gross average annual return of 7.0% (before fees) for 30 years. They both start with $100,000 and no additional contributions (for simplicity).
- Portfolio A has a management fee of 1.0% per year.
- Portfolio B has a fee of 2.0% per year.
So for Portfolio A the net return is approximately 6.00% (7.00% minus 1.0%), whereas for Portfolio B the net return is 5.00%.
Let’s compute the ending values roughly:
- Portfolio A: $100,000 × (1 + 6.00%)^30 ≈ $100,000 × 5.74 ≈ $574,000
- Portfolio B: $100,000 × (1 + 5.00%)^30 ≈ $100,000 × 4.32 ≈ $432,000
So simply by paying 1% more in fees each year, Portfolio B ends up about $142,000 less after 30 years (that’s nearly a 33% difference in outcome). If contributions were higher, or the timeframe longer, the gap widens even more.
1) How most mutual funds underperform their benchmarks when fees are taken into account
One of the key reasons fees matter is because many actively-managed funds fail to beat their benchmarks — after fees.
Research from S&P Dow Jones Indices’ SPIVA® scorecards shows that, over long horizons, the majority of active equity mutual funds underperform their benchmark indexes. For example: in the US large-cap equity category, 65% of active funds underperformed their index over a 20-year period.
According to Apollo, one of the world’s largest private investment managers, 90% of active public equity fund managers underperform their index over a 10-year horizon.
Why does this happen? A big part is that actively managed funds incur higher expenses (management, research, trading, marketing). That means the fund must gross outperform its benchmark by enough to offset those fees, just to tie the benchmark — and many fail to do so.
In addition, higher turnover, greater complexity, and sometimes “style drift” are extra risks that can weigh on net performance.
So when you pick a mutual fund, you’re not just hoping for good returns — you’re also fighting the drag of cost.
2) How small differences in fees can have a large compounding impact on portfolios
Let’s return to the idea of compounding — the “magic” of investing is that returns build on returns, year after year. But fees act like a “tax” on that compounding.
Every year you pay a fee, you reduce the base amount that gets to compound going forward. Over decades, this effect grows. One piece laid this out starkly: a difference of just 2.25% in fees over an investment lifetime could “deplete two-thirds of your retirement savings.”
Here’s a shorter illustration: suppose you invest $100,000 and expect a 7% annual gross return for 40 years.
- With 0.50% fees, net return = 6.50% → value ≈ $100,000 × (1.065)^40 ≈ $100,000 × 10.52 ≈ $1,052,000
- With 1.50% fees, net return = 5.50% → value ≈ $100,000 × (1.055)^40 ≈ $100,000 × 8.09 ≈ $809,000
Difference = $243,000 — nearly 30% of the retirement value is “lost” simply due to the higher fee. The gap gets bigger if you contribute each year, or if returns vary, or the time horizon is longer.
Also note: even a small fee difference like 0.20% vs 0.50% is meaningful. In our earlier 30-year example, the 1.0% difference also led to a 33% outcome difference. Over 40 years, that same difference would widen.
This is why the cliché is true: “every basis point counts.” A “basis point” is 0.01% — so shaving even 10 or 20 basis points (0.10%-0.20%) can pay off substantially when you’re investing for decades.
3) What investment vehicles typically have the lowest fees (ETFs vs mutual funds vs hedge funds)
When you look across different types of investment vehicles, there are material cost differences:
- Mutual funds: Especially actively managed mutual funds tend to charge higher fees. According to Fidelity Investments, the average equity mutual fund management fee is about 1.10%. Many industry sources say for actively managed mutual funds, a “good” expense ratio today might be 0.50-0.75%, with anything over 1.5% considered high.
- Exchange-Traded Funds (ETFs): These tend to have lower expense ratios, especially passive index ETFs. Because the fund is simply tracking an index rather than trying to pick winners, the costs are lower. For example, according to the investment company institute, index equity ETFs had average expense ratios around 0.15% in recent years.
- Hedge funds and alternative vehicles: These often carry much higher fees (often “2 and 20” – 2% management fee plus 20% of profits) and are less accessible to typical investors. Because of their high cost plus sometimes higher risk, many investors struggle to net meaningful outperformance after fees.
At the retirement paycheck company, we specifically use low cost ETF’s when building your portfolio to help minimize fees and maximize the size of your paycheck.
4) Industry trends towards lower fees
Fortunately for investors, the industry has been moving toward lower costs. Some key trends:
- According to the Investment Company Institute (ICI), the average expense ratio for equity mutual funds has dropped from around 1.04% in 1996 to 0.42% in 2023.
- Asset-weighted average fees for funds are also falling thanks to inflows into low-cost funds and outflows from higher-cost ones. For example, a recent study by Morningstar, Inc. noted the “fee war” among index fund providers.
- Article from the Associated Press: in 2023 US stock mutual fund investors paid on average $0.42 per $100 invested (i.e., 0.42%) — down from $1.04 per $100 (i.e., 1.04%) in 1996. For ETFs, the average was about $0.15 per $100 invested (0.15%).
- Big fund firms are publicly cutting fees. For instance, one major fund company announced a large sweep of expense-ratio reductions across dozens of funds.
These trends are encouraging because they make cost-efficient investing more broadly accessible. But the key takeaway remains: Limiting management fees is an easy way to help strengthen your overall financial plan.
Disclosure
These hypothetical examples are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. This does not represent any specific product [and/or service]. All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.