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Investment fees matter -- a lot

High fees eat away at returns. It's a critical insight highlighted by a New York Times story this morning, Pensions Find Riskier Funds Fail to Pay Off.

Searching for higher returns to bridge looming shortfalls, public workers' pension funds across the country are increasingly turning to riskier investments in private equity, real estate and hedge funds.

But while their fees have soared, their returns have not. In fact, a number of retirement systems that have stuck with more traditional investments in stocks and bonds have performed better in recent years, for a fraction of the fees.

What's true for pension funds and other institutional investors applies equally to individual investors. However, most individuals aren't investing with private equity, hedge funds and other alternative investment gunslingers. No, the investment that matters is mutual funds, since we put our money in the markets through retirement savings plans like 401(k)s, 529 college savings plans, IRAs and the like. Mutual fund fees compound, too. 

Low fees are a major reason for the sterling record of index funds compared to actively managed mutual funds. For example, in 2010, more than 60 percent of the assets in the S&P 500 index funds had expense ratios of 0.10 percent or less, according to the Investment Company Institute. The median expense ratio for all equity funds is 1.4 percent. "Actively managed mutual funds consistently fail to produce superior returns," says David Swensen, chief investment officer for Yale University's endowment fund and a legendary investor. "When taking sales charges into consideration, the failure of actively managed mutual funds reaches staggering proportions. In the final analysis, the benefits of active management accrue only to the fund management company, and not to the investor."

I've always loved this story for highlighting the role of fees. In 1940, Fred Schwed Jr., asked, with one of the most memorable Wall Street book titles ever, the right question: Where Are the Customers' Yachts? The book starts with a telling allegory: 

Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor.   He said, "Look, those are the bankers' and brokers' yachts."  

"Where are the customer yachts?" asked the naive visitor.

Every investor needs to ask of any financial product, "What will it cost me in total fees year after year?"

About the author

Chris Farrell is the economics editor of Marketplace Money.

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