The Fees That Quietly Eat Into a Small Investment

Did you know that fees are one of the main destroyers of long-term investment performance?

It’s true, and there are studies to prove it.

The groundbreaking work of economist Eugene Fama on efficient market theory showed that most active funds fail to beat the market over time, and that such funds’ underperformance is largely explained by their fees.

The implication is stark:

If you invest in high fee funds, you’re likely to get lower returns than the market averages. That holds true for both active funds – the most common type of high fee funds – as well as index funds with high fees. The latter category of fund is not that common but does exist.

Over time, fees can really eat into your returns. In this article, I explore the fees that quietly eat into a small investment and how you can mitigate their effects.

How high fees can get

Management fees are the main type of fee that eat into your investment returns.

The best-known examples of high management fees are found in the hedge fund industry. Here, funds sometimes charge the infamous “two and 20” structure, wherein the manager charges 2% on your principal and 20% on your gain. Typically, the 20% is only charged if the fund beats a benchmark’s return over a period of time.

There have been cases where hedge fund managers have gotten even more adventurous, charging AUM fees of 3% or more. I’ve even heard of cases of 3-and-30 being charged, but have never been able to confirm it. In the world of funds available to regular investors, a fee of 1% or higher is usually considered high.

“Hidden fees”

There are also “hidden” fees in the world of investment management. The most common of these is the bid-ask spread fee, which is an amount equal to the bid-ask spread, that market makers pocket as a commission. The smaller and less liquid an ETF is, the bigger this fee becomes. So, that’s one reason to invest in broad market funds.

Another type of hidden fee is execution costs. This includes things like trading costs incurred by fund managers. This type of fee is highest with funds that use options and other esoteric instruments. Again, you minimize it by investing in regular broad market funds.

How to avoid high fees

As mentioned repeatedly throughout this article, the way to avoid high fees in your investments is to hold broad market funds. These are funds that invest in an entire stock market – all of it, typically weighted by market cap – or a reputable stock market index. They don’t require active management, which lowers the management fee. They don’t use esoteric options, which lowers the total expense ratio. And finally, they’re usually pretty liquid, ensuring a narrow spread. They are the best of all possible worlds.

Consider the iShares S&P/TSX Capped Composite Index ETF (TSX: XIC), for example. It’s a Canadian index fund built on the S&P/TSX Composite Index, the 240 biggest public Canadian companies, weighted by market cap. The fund has a 0.05% management fee and a 0.06% expense ratio, very low. It has 220 stocks, which is decent diversification, and it is fairly representative of the underlying index. Finally, XIC is highly liquid, with a 0.03% bid-ask spread over the last few years. Overall, it’s a decent fund for most Canadian investors.