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One Factor Is the ‘Best Way to Stack the Deck' When Investing—But Many People Ignore It

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Everything from interest rates to corporate earnings to the amount of rainfall in a given year can affect the value of your portfolio. But these data points have nothing to do with you.

However, over the course of your career as an investor, there is one factor you can control that has a direct impact on the return you earn from your investments: what you pay for them.

Mutual funds and exchange-traded funds each come with annual fees. But unlike champagne and sports cars, a high price tag isn't a signifier of a fine product.

"It's the only consumer product where there is an inverse connection between quality and cost," says Christine Benz, director of personal finance and retirement planning at Morningstar.

That's because any amount that you pay in fees is going into the fund firm's pocket rather than into your investments. Over time, fees can massively affect on your returns.

"Choosing low fees is the best way to stack the deck in favor of choosing a good fund," says Benz. "The single most reliable data point we have for performance is fund expense ratio."

Here's how gravitating toward lower-fee funds can boost your returns over time.

Why certain funds tend to come with lower fees

The annual fee you pay to own a mutual fund or ETF is known as the expense ratio, expressed as a percentage of fund assets. If you have $1,000 invested in a fund with a 1% expense ratio, you'll pay $10 in fees over the course of a year, which ostensibly cover the cost of running the fund.

Fees vary from fund to fund, but one of the biggest differentiators is how the fund is managed.

Actively managed mutual funds are helmed by investing pros who build portfolios with the goal of beating a certain market benchmark. The cost of trying to beat a particular slice of the market is that the fund company has to pay someone (or several someones) to oversee the strategy — a cost they pass on to you.

Rather than trying to beat a market index, passively managed funds seek to replicate its performance. Because replicating the holdings of, say, the S&P 500 is relatively straightforward, there's no need for a highly paid manager to run the fund. For this reason, passive investments tend to be cheaper than active ones.

But wait, isn't it worth forking over some extra money to beat the market rather than match it? Theoretically, yes. But consistently outperforming the market is hard.

Take the S&P 500, a common benchmark for the broad U.S. stock market. Last year, 79% of active funds benchmarked to the index came in behind it, according to the S&P Indices versus Active scorecard. In fact, the average active fund has trailed the S&P for 12 consecutive calendar years.

How high fees hurt your returns

It's worth noting that some active funds have long-term track records of delivering outperformance over indexes, while others are purpose-built for niche corners of the market where investors can benefit from a manager's know-how.

"If I'm going spend on an expense ratio, it will be in a part of the market where a manager's expertise can improve my odds," says Doug Boneparth, a certified financial planner and founder of Bone Fide Wealth in New York City.

The good news for investors is that fund expense ratios are coming down across the board. In 2021, the average expense ratio for all mutual funds and ETFs was 0.40%, according to Morningstar — less than half of what investors paid on average in 2001. The average active fund charged 0.60%, while the average passive fund cost 0.12%.

Those numbers may seem negligible, but remember: Every dollar you pay in fees is one that could have been growing at a compounding rate along with the rest of your investments. So when comparing two similar funds, you're likely better off leaning toward the cheaper one.

Say an investor puts $10,000 into a fund charging an expense ratio of 0.60% and holds for 40 years, earning an annual rate of return of 7%. At the end of the period, the investment is worth about $118,000, with the investor having paid nearly $11,000 in fees, according to Bankrate's mutual fund fee calculator.

If you lower the expense ratio to 0.12%, the investment is worth about $143,000, with fees of about $2,500. Drop the ratio down to 0.03% — a common charge among major firms' broad market ETFs — and 40 years of sales charges total $636. The investment value: about $148,000.

"It's like [Vanguard founder] Jack Bogle used to say," says Benz. "'You get what you don't pay for.'"

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