If You Want Higher Investment Returns, You Need to Start by Minimizing Fees

Money is made in the small, unsexy details

Investors often focus on all the wrong things.

They will often focus on maximizing their returns through excessive trading and market timing, which lowers their returns.

They also focus on the shape of their returns with strong preferences for income-oriented investments like high dividend-yielding stocks, leading to tax-inefficient and poorly diversified portfolios.

In my upcoming book, The Investor’s Mindset, I devote an entire chapter to discussing the importance of focusing only on the factors you can control.

One factor you have complete control over — and which happens to have a huge impact on return — is how much you pay in investment fees. The frustrating reality is that many investors needlessly pay way more in investment fees than they need to.

In this post, I review why minimizing investment fees should be every investor’s top priority and why so many people pay unreasonably high fees.

If you want to juice your investment returns, start by focusing on your fees

As I covered in a previous post about dividend investing, rational investors should focus on optimizing their total returns and focus less on whether those returns come from dividends or increases in share prices.

Total returns for stock market investors = capital gains + dividends — investment fees & taxes

In that post, I highlighted that dividend strategies lead to unnecessarily high tax bills, which are a drag on returns.

Paying unnecessarily high investment fees might be a bigger mistake than paying more in taxes. Research from Morningstar found that investment fees are the best predictor of an investment fund’s total returns. Funds with the lowest fees provided investors with the best total returns.

The most common type of fee that mutual fund and index fund investors will pay is the “Management Expense Ratio” or MER, which is the fee paid to cover the costs incurred by the fund. An MER of 1% means you would pay $100/year for every $10,000 you invest — while an MER of 0.1% means you would pay $10/year for every $10,000 you invest.

Actively managed mutual funds have higher costs and MERs, which is one of the most important reasons index funds provide investors with greater total returns.

Why do so many people fail to minimize investment fees?

While minimizing investment fees is important for everyone — it is especially important for index fund investors.

All index funds have one job; replicate the underlying index.

There are many different S&P 500 index funds, and they all have the same job, which is to replicate the returns of the S&P 500 stock market index minus fees. Therefore, the rational investor will choose the S&P 500 index fund with the lowest fees.

Except, many index investors fail to minimize their fees. (Choi et al., 2010) found that participants in their study “overwhelmingly failed to minimize index fund fees.”

Investors in the study were much more focused on the annualized returns of an index fund since inception. It’s hard to imagine a less important factor in comparing index funds. Remember, the only job of an S&P 500 index fund is to track the S&P 500. All returns since inception tell you is when the fund was created.

Imagine two S&P 500 index funds:

• Fund 1 was created at the previous market peak prior to the COVID-19-induced crash in 2020.
• Fund 2 was created at the bottom of the market a month later.

Obviously, fund 2 will have much better “annualized returns since inception.” But that is absolutely meaningless going forward. All that matters is if the fund does its job of tracking the S&P 500 and the investment fees you need to pay.

But, the research shows that most investors are much more likely to pay higher investment fees for the privilege of investing in fund 2. The irony is that in doing so, they guarantee that they will have lower total returns than if they focused on what they can control; minimizing investment fees.

Investment firms will often trot out useless terms like “annualized returns since inception” to distract you from focusing on their higher fees — it’s kind of like a magician pulling a sleight-of-hand trick.

The issue of fees can get particularly complicated when investing in actively managed funds or with a financial advisor who provides other financial planning services through their fees.

This is where keeping things simple pays off.

If you’re a DIY investor, don’t bother with fancy alternative investments or actively managed funds. Stick with index funds and focus on minimizing investment fees.

If you work with an advisor, ask for a breakdown of how much of their fees come from providing financial planning services and how much comes from the investments they have you in. Always ensure you get value for your money — which means only paying for planning services you need and not having a portfolio of needlessly expensive funds.

Another reason that focusing on fees is important is that it’s a one-time decision that will save you money every year.

If you make lowering fees a priority, you’ll start out ahead of most investors.

Want to learn more about investing? Check out the MOAM crash course on passive investing

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.