The Expense and Tax Drag Audit
Turn warm and fuzzy percentages into cold cash to see what fees cost.
Schultheis argues that investors dramatically underestimate the cost of mutual fund expenses because they are quoted in small, innocent-sounding percentages. The average managed fund charges 1.54% annually versus 0.25% for an index fund. This 1.29% difference sounds trivial but costs $315,423 over thirty years of investing $500 monthly, assuming an 11% market return. When advisory fees of 1-2.5% are added (as many investors pay), total fees of 2.5% annually consume one-fourth of investment earnings and cost $508,789 over thirty years.
The audit framework converts these percentages into dollar amounts to break through the psychological numbness. It then examines the second drain -- taxes. Managed funds have average turnover ratios of 87% compared to 20% for index funds. This frantic buying and selling generates capital gains taxes whether or not the investor chose to sell. Analysis of the thirteen largest large-cap funds showed they kept only 85.43% of pretax profits, versus 94.20% for an index fund.
The greatest investment paradox, in Schultheis's view, is not that fund managers charge high fees to underperform -- it is that investors continue giving them money to do it again next year. The audit forces a confrontation with this paradox by expressing the cost in terms of specific retirement lifestyle sacrifices.
- A few cents in expenses expressed as percentages become hundreds of thousands of dollars expressed as cold cash.
- Mutual fund companies do not send monthly bills because if they did, investors would immediately see whether they are getting their money's worth.
- When stock markets return their historical 11-12% average, fees of 2-3% consume one-fourth of all investment earnings.
- The less you pay in expenses and taxes, the better off you are -- this is the entirety of the investment learning you need.
- Find Your Actual Annual ExpensesCall each mutual fund company or look up the fee table in your fund prospectuses. Every fund has one, including no-load funds. Add management fees, 12b-1 fees, and other expenses to get the total annual expense ratio. Then add any advisory or management fees you pay to a financial advisor.Pro tipIf you cannot find the fee table, call the fund company and ask directly. The number exists -- it is just buried in the prospectus.WarningNo-load does not mean no annual expenses. Every single mutual fund charges annual operating expenses that reduce your returns.
- Convert Percentages to Cold CashUsing compound growth tables, calculate what your annual expenses will cost in actual dollars over your investment time horizon. A 1.5% expense ratio on $500/month at 11% annual return costs $24,557 over 15 years and $315,423 over 30 years compared to a 0.25% index fund.Pro tipCalculate for both your current age to retirement and retirement to life expectancy. The longer the horizon, the more devastating the fee drag becomes.
- Assess Tax Drag from TurnoverLook up the turnover ratio of each fund you own. The average managed fund turns over 87% of its portfolio annually versus 20% for index funds. Higher turnover means more capital gains distributions, which are taxable even in years you did not sell any shares yourself.Pro tipIn taxable accounts, low-turnover index funds are especially valuable because they defer taxes until you choose to sell. The thirteen largest large-cap funds kept only 85% of pretax profits versus 94% for an index fund.
- Switch to Low-Cost Index FundsReplace high-cost managed funds with index funds at 0.25% or less. In tax-deferred accounts, you can do this without tax consequences. In taxable accounts, consider directing new money to index funds while holding existing positions to avoid triggering capital gains.Pro tipYou can build an entire diversified indexed portfolio across large-cap, small-cap, international, and bond funds for a blended expense ratio well under 0.25%.WarningIn taxable accounts, consult your accountant before selling existing fund positions, as the switch itself may generate a tax liability.
An investor saving $500/month at an 11% market return in a managed fund with 1.5% expenses ends up with $1,024,565 after 30 years. The same investor in an index fund at 0.25% ends with $1,339,988.
The average mutual fund manager is paid $475,700 annually to consistently underperform the stock market average. This salary comes directly from the annual expenses deducted from investors' retirement accounts.
During his Wall Street career, Schultheis repeatedly heard investors say they had 'no-load' funds and therefore paid no expenses. This fundamental misunderstanding revealed how successfully the fund industry had obscured the true cost of their services. He created the cold-cash conversion technique -- translating percentages into dollar amounts -- to pierce the veil of warm and fuzzy language surrounding fees.