What you need to know about investment fees

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What should I know before starting to invest? What is the difference between mixed mutual funds and exchange-traded funds (ETFs)? What are the costs for the different types of investment? Aion Bank spoke with Stock Market Expert Stefan Willems, who began his career in the trading room, monitoring the markets and writing for various financial papers. Today, he works as an independent analyst and, among others, writes for the Flemish Federation of Investors and regularly contributes to media sources such as De Standaard and MoneyTalk. On top of that, he is one of the driving forces (together with Jan Reyns and Pascal Paepen) behind Spaarvarkens.be, an initiative on how to consume wisely and save smartly, where they share their expertise in the investment world.

1. What are mixed mutual funds and ETFs and what is the difference between them?

Mixed mutual funds and exchange-traded funds (ETFs) are types of investment products comprising different assets such as shares, commodities or bonds.

They are very similar in their structure and serve as a way for investors to diversify their portfolios. However, there are important differences in the way they are managed and in the fees that are charged.

While mutual funds are actively managed by an asset manager whose objective is to do better than the market, ETFs follow the performance of an index (American S&P 500 and Eurostoxx 50 are examples) and seek to shadow the market rather than beat it.

The other important difference is with the fees charged for these investment products. Since mutual funds are managed by an asset manager, their fees are much higher than for ETFs, which are passively managed and have very low fees.

2. What are the fees when starting to invest in mixed mutual funds and ETFs?

If we go deeper into the fees aspect of these financial products, we see that the fees are very different:

ETFs: management fees usually amount to 0,2 – 0,5% of assets under management (AUM) a year.

Mutual funds: fees of 2,5-3% are charged for every purchase of a fund, then additional management fees - sometimes 10 times higher than for ETFs - can amount to above 2% of AUM. Finally, sometimes, closing a portfolio also requires an exit fee.

Why do ETFs require less fees? The answer is simple: since an ETF effectively tracks the performance of an index, the costly management fees to pay a fund manager, analysts and researchers are not needed.

If you look at the fees of mutual funds, it is very unlikely for a fund manager to be able to create returns better than the market, particularly if you look at a long term investment horizon of 10 years or more. 15% of fund managers are not able to achieve a better yield than the market because of the costs involved to pay all the people involved in the on-going management of the investment - fund managers, analysts, researchers, etc.

To illustrate the different fees of these two investment instruments, let us take the example of an initial investment of 10.000 EUR, for 20 years, with an average yield on the market of 7%. If we consider an ETF management fee of 0,2% and a mutual funds management fee of 2%, here is the result our investment would generate after 20 years:

The biggest danger with mutual fund fees is people not understanding how the fees work. In this example, 2% every year doesn’t sound like much, but investors need to remember to calculate these fees in nominal amounts. Think about the annual 2% fee as every day the mutual fund is taking a small part of the value of your investment, so the fees have a compounded effect over time and your investment is being slowly eaten away. In addition to the management fees, banks may also charge commissions for mutual funds.

In comparison, management fees for ETFs are much smaller. ETFs also carry Total Expense Ratio or TER fees, which refer to the total ETF issuer costs across your portfolio. The average TER of most ETFs is 0.2%-0.5%.

3. Do higher fees mean better performance?

As we have seen, mutual funds require more fees than ETFs. One legitimate question is whether higher fees mean better performance. If we look at statistics and academic research, mutual funds generally do not perform better than ETFs, precisely due to their very high fees.

I usually compare this to a lottery ticket: statistics show that only 15% of mutual funds managers can beat the market. You then pay a lot of money and hope your mutual funds manager will be among these 15%, but in practice, chances are very low.

Indeed, with mutual funds, it is difficult for the asset to grow because of the fee structure. Every day, the mutual fund is taking a bit of the value from your principal investment, but you do not see it.

For example, for a 50.000 EUR investment over 10 years, you will have paid your bank the value of a second-hand car in fees over the period. It is important to realise that traditional banks generate a lot of profits with the sale and management of mutual funds.

4. Does the risk profile influence fees?

When you start investing, you can choose a risk profile: conservative, moderate, or dynamic (agressive), according to the level of risk you want to take. When it comes to mutual funds, this risk profile has an impact on the fees you pay: the more dynamic your profile is and the more you invest, the more fees you pay.

On the contrary, for ETFs, the risk profile has almost no impact on what you are charged.

5. Some tips before starting to invest

Now that you know more about two common investment instruments, i.e. mutual funds and ETFs, let me give you some tips before starting to invest.

One first and general tip is to invest in the long term. Academic research shows that the longer you invest, the less risk you take. For this reason, you should at least have an investment horizon of at least 7 years. The longer your investment horizon the better your chance to not lose money. Statistically speaking, in a period of 20 years, the chances that you will have a negative yield on your investment is only 4 - 5%.

If you are looking for a way to invest that is rapid, easy and does not require high fees, ETFs are a very attractive investment. When choosing an ETF, you can either invest in ETFs following an index, or you can invest in ETFs following themes or emerging markets (such as technology, water, energy, etc.). To diversify your investment, I would advise to choose a mix of ETFs following a worldwide index and ETFs following emerging markets. Remember that ETFs do not require a lot of time to start and manage: it personally takes me a few minutes every month to buy some ETFs. Everybody can do it!

Investing presents numerous risks, conditions apply. More information: Aion Asset Management

Stefan Willems, stock market expert.

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