Investing in the stock market will generate positive real returns on wealth over long periods of time.  This is a much better alternative to holding cash, as inflation will erode the value of low-yielding cash; you lose value over time instead of gain.  Different investors pay wildly different prices to take part in the market.  There are several ways to invest in stocks, from doing it yourself (least expensive) to investing with a hedge fund that charges 20% of profits and 2% of asset value a year (most expensive).  This post examines the cost of each type of investing, and the importance of keeping fees low.

Keeping Down Costs Matters

The less you pay in investing fees, the more money you keep in your account to compound over time.  It really is that simple.  The average real (inflation-adjusted) total return for the S&P 500 (SPX) over the last 100+ years is about 7%.  If your investing costs you just 1% a year, you are giving away over 14% of your profits on average.  You don’t (or at least shouldn’t) invest for the fun of it, so giving away 14% of your reward for taking on investment risk is not a fair proposition (and that’s before taxes).

Maybe high fees are worth it…  Do high cost mutual funds outperform low cost funds.  The image below should put that notion to rest.  The image below shows that low cost mutual funds outperform high cost mutual funds regardless of asset class category.

Source:  Vanguard

Ways To Invest by Fees

There are a variety of ways to invest in the stock market.  The list below shows the cheaper options available for investors.  These options will generally be better than the most expensive ways to invest in the market.

1. Invest your own money in individual stocks
2. Invest your own money in low cost index funds
3. Low-cost virtual investment advisor
4. Fee only investment advisor (depending on fees and investment style)

The list below shows the most expensive ways to invest in the market.  These investment options should generally be avoided, unless you have a very very good reason why someone deserves high fees.

1. High cost mutual funds
2. Financial advisors
3. Hedge funds

High Cost Mutual Funds

According to Morningstar, the average U.S. equity based mutual fund has an expense ratio of 1.16%.  You pay the fund manager 1.16% of your invested wealth every year in hopes that they will outperform the market.  As the image above from Vanguard shows, this is not a good bet.  It gets even worse though.  Some mutual funds have much higher fees.  According to Morningstar, the mutual fund with the highest expense ratio in U.S. equities with over $300 million in assets under management is the Calvert Capital Accumulation fund (CWCBX).  The fund has underperformed the market since inception, not surprising, considering its high expense ratio of 2.86% a year (ouch!).

In addition to high annual expense ratios, mutual funds often have front-end and/or back-end loaded fees.  The amount of money you pay to invest in the market with a mutual fund does not make much sense considering how poorly high fee funds tend to perform.

Financial Advisors

There are great financial advisors out there.  Many are there to sell mutual funds, however.  As salespeople, financial advisors have an incentive to churn your holdings and put you in high cost mutual funds so they make larger commissions.  You should never invest with someone because they are ‘likeable’ or ‘your friend’.  The incentive structure for financial advisors is simply not in the investors best interest.

Hedge Funds

There are excellent hedge funds out there.  Most of them are closed to new investors because they are so successful.  If you can get into Seth Klarman’s Baupost Group, or Renaissance Technologies Medallion Fund, you should.  These funds are closed, however, and have been for some time.

For the majority of hedge funds out there, the fees more than eat up any benefit to investing.  The industry standard 2% of assets under management (more than the 1.16% mutual fund expense ratio) AND 20% of profits is ridiculous and very unfair to investors.  The image below shows how the HFRX Global Hedge Fund Index has performed (not well) versus stocks and bonds.  The HFRX Global Hedge Fund Index seeks to approximate returns of the global hedge fund universe

Source:  PrimNews

Fee Only Investment Advisors

Fee only investment advisors are a good option for investors who do not want to spend the time to research how to invest themselves.  When searching for an investment advisor, look for one that charges a low AUM fee (less than 1% is ideal) and invests only in individual stocks or low cost ETFs.  You are still paying the fees on the underlying funds your investment advisor puts you in, so you will be paying the investment advisors costs, plus the index funds you are invested in.

Low-Cost Virtual Investment Advisor

Virtual investment advisors offer low fee investment solutions to investors who are not comfortable investing themselves.  Virtual investment advisors tend to invest client funds in low-cost index funds or ETFs which keep fees low.  The two most popular low-cost virtual investment advisors are Betterment and Wealthfront.

Wealthfront’s charges 0.25% on assets under management.  The first $10,000 invested is not charged.  The company’s website says the average expense ratio for the ETFs it invests in is 0.15%, for a total expense ratio of around 0.40%.

Betterment charges 0.25% on assets under management for a $10,000 or more account, and 0.15% of assets under management for a $100,000+ account.  I would estimate underlying ETF fees are similar to Wealthfront, for a total expense ratio of about 0.30% for $100,000+ accounts.

Invest Your Own Money In Low Cost Index Funds

If you want to spend a minimum amount of time investing your own money while avoiding most fees, investing in low-cost index funds and ETFs is an excellent solution.  Different indexes charge different fees.  Fees for various equity indexes are listed below:

• Vanguard Total US Stock Market (VTI) – 0.05% expense ratio
• SPDR S&P 500 (SPY) – 0.0945%
• Vanguard Dividend Appreciation (VIG) – 0.10% expense ratio
• S&P 500 Dividend Aristocrats ETF (NOBL) – 0.35% expense ratio

As you can see, the fees for investing in low-cost equity ETFs are very reasonable compared with other investment options.

Invest Your Own Money in Individual Stocks

The lowest-cost investment method of all is investing in individual stocks yourself.  There is no expense ratio.  You have to pay a fee to your discount broker, which generally ranges between $5 and $10 a transaction.  If you have a low turnover ratio and keep a fairly concentrated portfolio of about 20 stocks, broker feeds will be well under $200 a year.

The Sure Dividend newsletter plan espouses investing in the top ranked stock you own the least each month.  This would create annual brokerage costs of between $60 and $120.  Sure Dividend is meant for long-term investors, so selling happens very infrequently.  If you assume 1 to 2 sales a year, total brokerage costs would be $65 to $140 a year for an expense ratio of 0.06% to 0.14% on $100,000.

Note:  Keep in mind the same brokerage costs would be incurred for investing in ETFs on a monthly basis, which was not discussed above.

Fees on Your Portfolio Using Various Investing Methods Per Year

1. Investing in Individual Stocks Yourself (with Sure Dividend)
   Sure Dividend Annual Cost:  $80
   Estimated Brokerage Costs:  $65 to $140
   Expense Ratio on $100,000:  0.15% to 0.22% ($145 to $220 per year)|
   Expense Ratio on $1,000,000:  0.015% to 0.022% ($145 to $220 per year)

1. Investing In ETFs Yourself
   Average Low-Cost ETF Expense Ratio: 15%
   Brokerage Cost (assuming monthly investing):  $60 to $120
   Total Expense Ratio on $100,000:  0.21% to 0.26% ($210 to $270)
   Total Expense Ratio on $1,000,000:  0.16% ($1,560 to $1,620)
2. Virtual Investment Advisor
   Betterment Fees on $100,000 (including ETF Fees):  0.3% ($300)
   Wealthfront Fees on $100,000 (including ETF Fees): 0.4% ($400)
   Betterment Fees on $1,000,000 (incuding ETF Fees):  0.3% ($3,000)
   Wealthfront Fees on $1,000,000 (including ETF Fees):  0.4% ($4,000)

The 3 options above are the most economical.  After these three options, fees start to increase rapidly.  An investment advisor charging 1% investing in individual stocks would cost $1,000 per year on $100,000 or $10,000 per year on $1,000,000.

A Hedge Fund that made 10% a year before fees would have an after-fee return of 6% a year (assuming 2%/20% fee structure).  This would come to $4,000 per year on $100,000, or $40,000 per year on $1,000,000.  If you have a million dollars (or more), I’m sure you can think of a better way to spend $40,000 than on padding a hedge fund managers bank account.

Final Thoughts

Many investors never think about the impact fees have on their returns.  Over time, even small differences in returns add up to large amount in your fees.  You cannot control all aspects of investing.  You can control the amount of fees you pay to the financial industry.  The less money they make, the more you keep in your account, and the faster your wealth will compound.