By Matt Becker

Posted March 20, 2014

In investing, you get what you dont pay for

-John Bogle

Do you want to know what the single best predictor of future investment returns is?

Its not past performance. Its not the investors skill, or experience, or education. Its not future interest rates, or what the Fed is doing, or anything like that.

Its cost.

Keeping your investment costs low gives you the best chance for better investment returns. Pure and simple.

And this is great news! Because while there are about a million parts of the investment process that you have no power over (what the markets are doing, inflation, interest rates, etc.), cost is something that YOU can directly control. You can easily make choices that lower the cost of your investments and improve your returns in the process.

But if you want to keep your investment costs low, you need to know what to look for. Heres a primer to help you get started.

How do we know that costs matter?

Before we get into the nuts and bolts of looking at the cost of your investments, lets take a step back and ask why we should care so much about costs in the first place.

To start, its simply logical that every dollar you pay to make an investment is a dollar that isnt earning you returns from that investment. If you have $10 to invest but it costs be $1 to do it, youve only invested $9. Over time that can make a big difference (as well see below).

But we dont have to rely just on logic. Morningstar has actually done the research and found costs to be the single best predictor of future mutual fund performance. even better than their own star rating system thats made them so famous.

And since most of us will be investing in mutual funds (since stock-picking almost never works ), Ill focus the conversation here on the types of costs most commonly associated with mutual funds and what you can do to minimize them.

You can use a site like Morningstar  or Yahoo Finance  to research a specific mutual fund for any of the things Im going to talk about here. If youre investing within a 401(k), you should ask your company for a list of funds and the fees associated with each, as they may be different than what you find online.

Expense ratio

Every mutual fund will have something called an expense ratio, which is a percentage of your money thats taken out of your investment every single year to pay the costs of running the fund. It handles things like paying the managers who run the fund, administrative costs, and the like.

As an example, lets say a mutual fund has an expense ratio of 1% and you have $10,000 invested in that fund. That means that 1% of your investment is taken out of your account every year, which with a $10,000 investment would come to a $100 charge.

Even a seemingly small difference in the expense ratio between funds can add up to a HUGE difference over time. Heres an example showing just how much it matters:

In both cases, the investor is contributing $10,000 per year and getting an 8% return over 30 years. But when the expense ratio is 0.2% vs. 1% (only a 0.8% difference!), the end result is $166,553 more for the lower-cost fund. I dont know about you, but that kind of money would make a difference in my life.

There are lots of great mutual funds (mostly index funds) with expense ratios right around 0.20%, and sometimes even less. If it were me, Id have to have a REALLY good reason to pay much more than that (and honestly its hard to think of what that reason might be).

12b-1 fees

The 12b-1 fee is also expressed as a percentage and is typically already included in the funds expense ratio. But when you look at a mutual funds information youll see it displayed separately from the expense ratio because its not really a cost of running the fund. Its a cost of promoting the fund, primarily paid to financial institutions who sell the fund. In other words, its essentially a commission.

While the existence of a 12b-1 fee shouldnt automatically send you running, its a cost that should likely be avoided if possible. It doesnt serve to help you (why should you care if the salesman gets a commission?), and it does take money out of your pocket year after year. And there are plenty of great funds that dont include these fees.

Loads

A load is a commission paid to the person who sells you the mutual fund. The most common is called a sales load, or front-end load, and its a percent of your purchase amount each time you buy some of the fund.

As an example, a mutual fund might have a 5% sales load, in which case $50 out of every $1,000 you invested would be paid to a salesman instead of your account.

Just like with the expense ratio, we can look at two different funds, one with no sales load and one with a 5% sales load, and see how the end result looks after 30 years of investing $10,000 per year (in monthly contributions of $833) with an 8% return:

Not quite as dramatic as the expense ratio, but $62,554 is still a significant amount for a fee that can easily be avoided and provides no benefit to you.

There are also back-end loads, sometimes called a contingent deferred sales load (who makes up these names?). This works the same way except that the charge is applied whenever you decide to sell your shares of the mutual fund.

There is plenty of evidence that you should NEVER purchase a mutual fund that includes any kind of load. They typically perform worse than similar mutual funds that dont have a load, even BEFORE you factor in the extra cost. So that extra cost is essentially just money that the salesman is asking you to throw away.

Transaction Costs

Transaction costs are the least transparent of all. These are the various costs incurred by the mutual fund whenever it makes trades.

Note that this is different than when YOU make trades. The mutual fund itself will buy and sell stocks or bonds or whatever it invests in, and those transactions have a cost. Different studies have found these costs to be anywhere from 0.1-2% per year. which can be a huge drag on your returns.

Theres no real good way to understand a funds transaction costs, but the best way I know is to look at whats called turnover. Turnover measures the percent of the mutual funds holdings that change in a given year. A turnover rate of 100% means that the fund changes all of its holdings during a given year.

A higher turnover means the fund is making more trades, which means its more likely to have higher transaction costs.

As a point of reference, a good index fund like Vanguards Total Stock Market Fund (VTSMX) will have a turnover rate in the low single digits. That kind of low turnover can do a lot to keep costs low.

Taxes

If youre investing within a retirement account like a 401(k), IRA or 403(b), then you dont have to worry about this part of the conversation. Those types of accounts have tax preferences that make these points moot.

But if you have any money in a regular old brokerage account, taxes can be another hidden cost that can really hurt your returns.

When a mutual fund makes a trade, there may be tax consequences. Interest earned from a mutual funds bonds is taxable. Dividends earned from a mutual funds stocks are taxable. All of these things will be treated differently based on the specific mutual fund and the specific investor, but its worth paying attention to because the more you pay in taxes, the less youre able to use for yourself.

One simple but imprecise way to estimate the tax cost of a fund is to again look at turnover. In general, funds with a higher turnover will have a higher tax cost (though this is subject to some debate ).

If you want to get more precise, the Morningstar has a measurement called the tax cost ratio that can help you determine how tax-efficient a given fund is. You can search for a fund and then look at the funds Tax tab to see its tax cost ratio displayed as a percentage in the same way that the expense ratio is displayed. A higher number here indicates that you should expect to pay more in taxes.

Investment costs are one thing worth worrying about

The bad news is that there are lots of potential costs out there to watch out for.

But the good news is that you have the ability to directly influence the amount you spend on your investments, and that decision has a direct impact on your end result. Its something that both matters AND is in your control. Thats actually pretty rare in investing.

Let me also say that cost is not the only thing you should worry about. There may be a fund that costs slight more but fits better in your personal investment plan. and that might be reason enough to choose it. Costs shouldnt be the be all and end all.

But costs do matter. A lot. And if you can choose good investments at a low cost, youre setting yourself up for a long run of good results.

Photo courtesy of ansik