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Understanding Your Real, Real Returns – Fee Edition

A recent post of mine discussed the importance of understanding your real, real returns (see here).  That is your return after fees and inflation.  We don’t usually hear about this return which is really strange because it’s the money that actually goes into your pocket.  The 10-12% nominal return we often hear about the stock market is not the real, real return and I have no idea why anyone cites such a figure as it plays no realistic role in your life.

When we put that 10-12% figure in perspective the stock market actually looks like a far less sexy place to make money.  In fact, the real, real return in stocks over the last 30 years has been just 5.97%.  But what eats away at that top line figure?

We all know the story on inflation over the long-term and certainly in recent years.  Historically, it runs about 3.5% although it’s been much lower in recent years.  But it’s still the biggest chunk reducing your returns.  Leaving your assets in cash form is generally a dreadful idea over any sustained period of time, but it’s shocking how many people do this.

But what doesn’t get as much attention is the adverse fee effect.  If you’re looking at a real return (after inflation) of 6-7% in stocks then we have every reason to be mindful of any other frictions like taxes and fees that might reduce that return even further.  But what is the average fee effect?  To put things in perspective consider that the average mutual fund charges 0.9% relative to the average low fee index which charges 0.1%.  That’s a 0.8% difference.  It doesn’t sound like much, but take a 7% compound annual growth rate on $100,000 and extend that over 30 years.  Just how much of an impact does it make?  The mutual fund ends up with a balance that is 23% lower than the index.  In other words, the mutual fund could just mimic the return of the index and reduce your return by $150,000.



What’s really frightening about this is that most of the 401K space is captured by high fee funds.  As Ben Carlson notes, less than 20% of existing funds in 401K plans have an expense ratio lower than 0.5%:

“Less than 20% of these funds offer expense ratios of less than 0.5%, but more than half charge 1% or more in expenses. More than a quarter of these funds still charge more than 1.5% and almost one in ten charges more than 2%. There’s no way that this many funds deserve to be charging this much for their services, especially when you look at the dreadful performance against simple index funds over time.”

This is madness.  And I agree with Ben – I don’t just hope it changes.  It needs to change.  Of course, we should be mindful about portfolio construction with the understanding that the “allocation matters most hypothesis” trumps the “cost matters hypothesis”, but fees in this business are ripe to come down.  Way down.  And that’s a good thing.