Getting Real About Fund Fees

So it’s time to get real about mutual fund fees. Sure, they’re lower than ever for many funds, especially those that track an index. In fact, the average fund fee is now 1.25 percent, according to Chicago-based Morningstar.

Still, even this amount is too high and needlessly gives away most of your expected future gains.

To understand this, consider the following:

1. You have to frame your gains in real, after-inflation returns. In other words, your portfolio must match inflation just to keep your spending power intact.
2. You have to set reasonable expectations for future stock and bond returns.

These days, the stock market certainly has been on a tear. Though many of us may be aware that stocks have more than tripled from the low of March 9, 2009, few recognize that the total return on U.S. stocks is 60 percent from when stocks peaked on Oct. 9, 2007, the very height of the financial bubble. That equates to about a 6.7 percent annualized return, which far outpaces inflation, even after taxes.

So, the question these days is: Can that growth be sustained? Many experts are advising investors to lower their expectations. Nobel Prize-winning economist Robert Shiller says that stocks are very richly valued now. According to his CAPE index, which measures stocks in real terms, stocks have been this richly valued only in 1929, 1999 and 2007. Plunges occurred right after these valuations.

Bonds will almost certainly have lower future returns than in the past. That’s because bonds increase in value when interest rates decline. But interest rates can’t fall too much further, since they’re already approaching zero.

In his book Rational Expectations, financial theorist William Bernstein predicts a 2 percent real return for large-cap stocks and 3 percent for small-cap stocks over the next decade. Robert Arnott, chairman of Research Affiliates, forecasts a 3 percent real return over the next decade. Let’s assume a 3 percent real return. Forecasts for bonds I’ve reviewed show expected real returns between 0.5 percent and negative 1 percent. Let’s assume zero, meaning that bonds keep up with inflation.

So if you have a portfolio of half stocks and half bonds, a reasonable expectation of future returns is about 1.5 percent (an average of 3 percent for stocks and zero for bonds).

Now, unfortunately, the 1.5 percent forecast is before fees. So if your funds are charging 1.25 percent, then you are giving away more than 83 percent of your forecasted returns. Even if these forecasted real returns are too pessimistic and actual real returns average 2.5 percent, you would still be giving away half of the expected real return.

How do you get around that? There’s a simple solution. If you are taking on all of the risk, give away as little of the reward as possible. Index funds from firms such as Fidelity, Schwab and Vanguard, among others, have fees as low as 0.04 percent. If you feel that managing a portfolio is too hard, consider using one of the Lazy Portfolios of index funds that need very little of your time. I’ve reviewed hundreds of professionally managed portfolios over the years and few have matched these low-cost, simple portfolios.

Photo: Seigler/istock

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