How 1% becomes 30%.
Mutual funds make money by charging fees to unit holders. Good or bad, up or down, fees are deducted from unit values. Management Expense Ratios (MER) typically range from 1% to as much as 3% each year. This means that even if you’ve purchased the lowest costing mutual funds (e.g., MER=1%), each year 1% of your money is deducted from your account to pay for all expenses. These expenses include trading fees, administration fees, as well as compensation for the fund managers and the people who sold you the funds.
To be clear, this is not just 1% of your contributions that year. It is 1% of your ENTIRE ACCOUNT – EVERY SINGLE YEAR.
Let’s use the following example to understand the actual cost of 1% per year over a 40 year investment horizon. In this example, let’s assume you had invested $500 each month for past 40 years and achieved a rate of return of 10% per year. [Incidentally, the entire US Stock market (S&P 500) achieved a rate of return of over 11.4% per year over the last 40 years(see this)].
$500 invested each month for 40 years at 10% return per year = $2,797,304
Conversely, if you had to pay a 1% annual fee to a fund manager for the same level of performance (most do not even do that – see, for example, https://www.marketwatch.com/story/why-way-fewer-actively-managed-funds-beat-the-sp-than-we-thought-2017-04-24), your average rate of return would have been 9% per year.
$500 invested each month for 40 years at 10% return per year = $2,124,824
That’s a difference of $672,480 – 31% less. Put another way, over a 40-year investment horizon, you would’ve paid your mutual fund company well over half a million dollars to try to beat the market. By the way, you can check the math here.
Of course, you may argue that a 1% annual fee (or more) is justified if the fund managers are able to add more than that much value (e.g., by beating the overall stock market by more than the MER they charge). Sadly, as we’ll discuss in subsequent posts, this is rarely (almost never) the case.