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3 Myths About Investment Fees

Last update on: Jun 18 2020
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Myths about investment fees are widespread among investors. The myths include mutual fund management fees. As a result, many investors pursue the wrong investments and earn lower returns than they should.

It is easy to understand how investors stray down the wrong path regarding fees and expenses. Of the main elements of investment management – return, risk, and cost – cost is the one over which investors have the most control. In addition, the heavy promotion of index funds and exchange-traded funds over the years has emphasized their low cost in relation to actively managed mutual funds.

As a result, some investors overemphasize fees over other factors. These actions have gone so far that the Journal of Portfolio Management recently published an article titled “Five Myths about Fees.” Not all the myths discussed apply to mutual fund investors, but there are several that individual investors should consider.

Fees should be as low as possible. This is the first myth. I regularly run into investors who believe this when I give presentations. Often, at least one person in the audience asks about the expense ratios of the funds I recommend and questions why they should buy a fund that doesn’t charge the lowest fees.

The focus should be on the best returns, adjusted for the risks taken, after fees. The case for low fees is that they increase the probability of earning a higher after-fee return. The highest fees are often are charged by broker-sponsored funds that earn mediocre returns.

But there are many mutual funds from which you get what you pay for. These funds charge more than index funds and sometimes more than the average fund. But they earn their fees in several ways. They often reduce risk by losing less than index funds in market downturns. Over the long term, they earn more than the index funds.

Most investors seek out the lowest-fee funds, because those funds are easier to find than those that reduce risk and increase returns. But we have been able to find those funds over the years and earn more than the indexes. Mutual funds and money managers that can deliver returns consistently above the indexes and reduce risk should be paid higher fees.

Incentive fees always are best. Most mutual funds and money managers charge a fixed percentage of assets. But some mutual funds, most hedge funds, and a number of money managers charge incentive fees. They earn higher fees by earning more than an index or a fixed return. Most investors believe that some kind of incentive fee is better than a fixed percentage fee or even a fixed dollar fee.

One problem with an incentive fee is that it encourages the manager to take more risk in order to try for a higher return. The investor could end up with steep losses because of the fee structure. If the manager suffers losses early in the year, the incentive fee gives a temptation to take even more risk the rest of the year to overcome the losses.

In addition, it is difficult to determine when a manager earned a higher return through skill and when it was earned by taking higher risk or through luck. A higher return should be paid only for a skill that can be repeated.

Our experience with our mutual fund “hedge funds” shows that investors can earn high returns with reduced risk while paying regular mutual fund fees of a percentage of assets under management. Paying 20% of profits to a hedge fund manager is not necessary to earn hedge fund returns and risk reduction.

Hedge funds are where the talent is. The high incentive fees charged by hedge funds allow their successful managers to earn a great deal of money.  That has convinced many in the financial services business that the bulk of the talent is going to hedge funds. Traditional mutual funds and money managers retain only the second and third tier of talent, so incentive fees are necessary to earn top returns.

Again, we have shown with our fund selections that higher returns with low risk do not require incentive fees or hedge funds. Many talented people are content to work for the high compensation awarded to the best mutual fund managers. In addition, incentive fees do not automatically lead to better performance. There are many mediocre or poorly performing hedge funds. Each year, it is estimated that about 20% of existing hedge funds close, primarily due to poor performance.

Fees are only one piece of the investment management picture. Too many investors focus exclusively on fees, because it is the one thing they can control. When focusing on fees, it is important to separate popular myths from reality so that the right decisions are made.

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