In this article, we look at index funds and mutual funds (also known as unit trusts) to explain how the fees differ in type and magnitude..
An index fund or exchange traded fund (ETF) mimics a market index by purchasing shares in the same proportion as the companies that make up the index. The S&P 500 is a well-known index that consists of approximately 500 of the largest (measured by market capitalisation) listed companies in the United States of America. The Vanguard S&P 500 ETF (VOO) exchange-traded fund mimics the S&P 500.
The Vanguard S&P 500 expense ratio is 0,14% meaning for every $1 invested; they charge 0,14c in fees. That is 14% of 1c!
The Vanguard S&P 500 is the only ETF to achieve this low cost as they earn most of their income by lending their shares to other fund managers who go short of shares. Before you can sell shares you do not own (going short) you have to borrow the same amount of shares you want to short through your broker.
The fees associated with Index investments are assumed to be low. However, when looking at the dividend return on an ETF it becomes clear that the costs of the ETF eat into the dividend return as they are often well below that of the Index. The VOO is the exception and not the norm!
A mutual fund or unit trust is an investment fund made up of a group of shares that are selected by a fund manager, with the intention of meeting the fund investment goals.
Mutual fund/unit trust fees are typically made up of the following fee components:
- 1. The Total Expense Ratio (TER) which covers the cost of portfolio management by the Asset Manager. This cost is available on the Fund Fact Sheet. In some cases it could be as high as 3.5%.
- 2. Trading costs or transaction fees are a separate fee charged to cover the cost of trading the shares. These fees are paid when the fund manager buys and sells shares for the fund. The more actively managed the fund, the higher the trading fees will be. These costs are not visible. This is a cynical part of the industry. Most shares are held for less than a year by a Mutual Fund and this can drive 0.6% in invisible fees.
- 3. Advisor fees are the sales commissions that are charged by the financial advisor whom you may have engaged to help you choose the best funds and define your investment strategy. Advisor fees of 1% are not uncommon but are mostly around 0.5%. There have been significant changes in some countries, where these fees are charged according to the hours spent on the client.
Understanding all the separate costs, how they are charged and how much they add up to will go a long way towards understanding the impact that that those fees have on your investment. Also consider, depending on the fund that there may be potential penalties and fees if you withdraw from the fund before a certain date.
Investment fees do have an impact on your investment performance.
Warren Buffett is often quoted as recommending index funds, but without including the relevant context. Buffett is clear in his 1993 investor letter, where he recommends indexing for the “know nothing” investor. This type of investment is recommended for an investor that has no accounting knowledge and is not interested in understanding how companies work. He specifically recommends the Vanguard S&P 500 Index Fund (VOO). He uses his wife as an example of a “know nothing” investor.
He advises the “know something” investor to invest in a few businesses within your circle of competence, that you know well and that can be purchased at a decent price. At AXIAM, we regard ourselves in this category.
The above advice is there to avoid the high fees for Hedge Funds, actively managed Mutual Funds, Private Equity Funds and other expensive financial products.
At AXIAM we focus on a long-term investment strategy built on 11 Investment Principles gleaned from the world’s great investors like Warren Buffett, Howard Marks and Charlie Munger. We study companies that own great brands, generate strong and growing cash flows and have low debt to equity ratios. Contact our team or sign up for our newsletter if you would like to learn more about investing your capital to provide ongoing retirement income.