Impact of mutual funds fee
Saving for retirement may involve buying stocks and bonds. Or mutual funds.
With stocks and bonds, we do the research of identifying which to buy. With mutual funds, the professionals who manage the funds do the research for us.
For a fee, of course.
The fee is to cover transaction costs and whatever costs the professionals incur, plus their salaries, etc.
I have read that fund fee / cost affects the real return of my savings, if I save using mutual funds. I had read the explanations many times, but my brain could not internalise the impact.
I searched the internet, but did not find any explanation that could satisfy me. The articles that I read explains the incurred costs. But they did not explain the impact to return in ways that I can internalise.
(Or something in my brain prevented me from understanding it. 🤔)
Out of curiosity, I constructed my own calculation from scratch. And the "light bulb" turned on in my brain. I got it.
Let me step back a bit and reconstruct the steps.
Read the prospectus
The data we need is available in the mutual fund’s prospectus. What we need is (a) the past fund performance and (b) the fund fee.
Note that past performance is no guarantee for future performance. We are using the data for the purpose of simulation exercise.
Simulate the return
For illustration purpose, all data is imaginary data; not real data. And pick any currency you want.
Example Fund A
Initial amount 1,000
Past fund performance 10%
Fund fee 2%
The initial 1,000 increases by 10% and becomes 1,100. The fund fee of 2% from 1,100 is 22. So 1,100 deducted by the fund fee of 22 becomes 1,078.
In this specific example, the return is 1,078 - 1,000 = 78 or 7.8% of the initial amount.
Simulate different fund(s)
Example Fund B
Now I assume a different fund with the same performance but different fee.
Initial amount 1,000
Past fund performance 10%
Fund fee 1.5%
The initial 1,000 also increases by 10% and becomes 1,100. The fund fee of 1.5% from 1,100 is 16.5. So 1,100 deducted by the fund fee of 16.5 becomes 1,083.5.
In this specific example, the return is 1,083.5 - 1,000 = 83.5 or 8.35% of the initial amount.
Next, let me assume another fund. Lower performance but even lower fee.
Example Fund C
Initial amount 1,000
Past fund performance 9.47%
Fund fee 1.02%
The initial 1,000 increases by 9.47% and becomes 1,094.7. The fund fee of 1.02% from 1,094.7 is 11.17. So 1,094.7 deducted by the fund fee of 11.17 becomes 1,083.5 (rounded down).
The return for this example is 1,083.5 - 1,000 = 83.5 or 8.35%.
Compare
Now I compare them side by side.
Comparing Fund A and Fund B, I see that given identical performance, B’s net total is greater than A’s.
Comparing Fund B and Fund C, they both have the same net total and potential return %, although C has worse performance.
Negative scenario
Funds do not always go up.
Next, I simulate the funds as if they all have negative performance. The calculation steps are the same as above. Initial amount and fees are the same as before. I only changed the input for fund performance data.
Comparing Fund A and Fund B, I see that given identical performance, B’s net total is greater than A’s.
Comparing Fund B and Fund C, they both have the same net total and potential return %, although C has worse performance.
Takeaway
Fund fee indeed has an impact.
I can use the steps above to calculate the potential return of every fund that I am interested in. And then compare them side by side.
Every mutual fund has different characteristic and risk profile; not just different performance. Fund fee has an impact, but it is not the only factor that matter in mutual fund selection. You should consult your financial advisor!
I am sharing how I calculate potential return in the hope that this can spur you into doing your own learning. If you spot an error in the examples above, please email me.
Have a great day.
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Disclaimer: Anything I share is not intended as financial advice; I am merely sharing personal opinions and experiences. The information is of general nature and you should only use it as a place to start your own research and you certainly should do your own due diligence. You ought to seek professional financial advice before making any decisions.