Are Low-Fee Investments the Key to Long-Term Wealth? Not Necessarily

MarketsMotley Fool

We hear a lot about the importance of keeping our investment fees to a minimum. After all, the less money we lose to fees, the more we get to keep for ourselves. It's that simple. But a new study by United Income shows that when it comes to fees, sometimes you really do get what you pay for.

These days, there's a plethora of low-fee management firms and products out there (think exchange-traded funds and the like) designed to save investors money. And investors are taking advantage of that very opportunity. Since 2005, over 95% of personal investments have been in products that fell, or fall, within the cheapest 20% of those available on the market. But according to United Income, the benefits of lower investment fees may be negated by what it calls outside non-fee costs. These non-fee costs include higher taxes than necessary, or losses resulting from underperformance or overexposure to riskier investments. And that's a good reason to question whether low-fee solutions are always the way to go.

Continue Reading Below

When fees are a good thing

The logic behind avoiding hefty investment fees is simple: The more you fork over for the privilege of investing your money, the more you stand to lose over time. That's because as your returns compound and your asset level grows, your fees increase proportionally so that after, say, 30 or 40 years, you could really end up losing a bundle. (Remember, if you start off with a $10,000 investment and lose 3% to fees, that's just $300. But if your portfolio value increases to $300,000 over time, and you're still paying a yearly 3% fee on your investments, that's $9,000 -- quite the difference.)

That's why investors are often advised to go out of their way to avoid fees -- namely, by choosing low-cost products like index funds, or management firms or advisors whose fees fall well below the average. But according to the aforementioned study, the savings you'll get by going the low-fee route could be wiped out by non-fee costs you'll incur instead.

Specifically, United Income analyzed 68 distinct low-fee money management solutions and found that 75% of them created potentially higher-than-necessary non-fee costs for clients. In fact, roughly 95% resulted in potentially inflated tax bills and reduced individual investment returns as a result of oversimplified approaches. By contrast, only about 5% of these so-called low-fee solutions managed to address these non-fee costs.

Why is this important? Namely, because the study also found that reducing non-fee costs could generate seven times more wealth in retirement for the typical investor.

Case in point: An average investor might generate a good $40,000 in additional wealth by sticking to a low-fee management solution. At the same time, a higher-fee solution that accounts for non-fee costs might generate over $340,000 for that same investor by limiting negative tax consequences and minimizing investment losses or missed opportunities for better returns. These numbers, by the way, assume a median market outcome throughout the investment period in question -- meaning, the market on a whole isn't particularly weak or strong, but rather, sits somewhere smack in the middle.

What's right for your portfolio?

So where does all of this leave you, as an investor? It's simple: You may need to start doing a better job of vetting your money manager, or money management solution, and determining whether your fee-related savings are costing you in other ways. This means that if you're working with a financial advisor, it pays to sit down with that person and ask what steps he or she is taking to minimize your exposure to higher-than-necessary taxes, underperformance, or excessive risk.

Keep in mind that it's common practice for financial advisors to use money management programs to devise individual strategies. In other words, you might think your advisor is sitting there racking his or her brain in an effort to cultivate a customized strategy for you. But what he or she might actually be doing is plugging your data into some type of software and waiting for it to spit back a low-fee solution to your investment needs. And while that's a good thing in theory, you'll need to make sure it ultimately serves your savings well. If there's one takeaway here, it's that it just might pay to fork over a reasonable premium for a more active money management solution -- especially one that accounts for the non-fee costs that could ultimately derail your quest for added wealth.

The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.

Continue Reading Below