I was doing a little financial “spring cleaning” a few days ago and reviewing one of my wife’s old brokerage accounts. I uncovered a few things that I thought would make an interesting post. As a bit of background, the brokerage account was started in 2004 by Random Gal’s mom. I’m not sure whether it started out as a custodial or joint account, but as of right now my wife is the account holder. Although this is the case, her mom remained the primary “investor” until recently. She relinquished control of the account to us and I got the OK to start managing the assets. The first thing I did was to review the investment holdings, and boy was it a revelation!
When I pulled up the account summary screen, I was surprised to find a total of 13 different mutual funds! There were also holdings of seven individual stocks and a cash/money market account. The individual stocks were actually not that bad, but the mutual funds were a nightmare!
Lots of Holdings ≠ Diversification
Holding a lot of different mutual funds does not necessarily equate to diversification. In looking at each individual mutual fund, I found some overlap and redundancies. Of the 13, there were three large cap value funds, two large cap growth funds, a world equity fund, an international fund, and a balanced fund that holds stocks, bonds, and cash. Does one really need three different large cap value funds? In my opinion, no they don’t.
Check Your Fees!
Not only was there some overlap between different funds, there were also high fees associated with these holdings. Out of the 13 funds, none are index funds, which means that all of them are actively managed funds. I haven’t talked much about my investment style and philosophy (topic for a future post), but in essence I am a fan of passive index funds and minimization of fees. All of the funds have 12b-1 fees, and nearly all have some kind of load fee. In terms of expense ratios, the lowest one was 0.85%. The highest expense ratio was a whopping 2.09%! I nearly threw up on myself and my laptop when I saw these fees. This link summarizes the different kinds of mutual fund fees and expenses.
The Eroding Effect of Fees
I’m a big fan of minimizing fees. I think it’s one thing that you can control that can help maximize your investment returns. The less you pay in annual expenses, the more of your returns you get to keep. Like compound interest, fees can add up over time. And not in a good way! The table and graph below shows the returns of an initial, one time investment of $10k using different expense ratios (ER) and assuming an annual return of 5%.
|ER||Year 0||Year 10||Year 20||Year 30|
For this example, I used the highest and lowest expense ratios from the aforementioned mutual funds (0.85% and 2%) and compared them with the expense ratio of Vanguard’s Total Stock Market Index Fund Investor Shares (0.16%). As you can see, fees can add up over time and erode the returns of your investments. After 30 years, the difference between the most expensive fund and the Vanguard fund is over $17k.
Plans Going Forward
Our ultimate goal for this brokerage account is to simplify and streamline the holdings. We’ve decided to keep the individual stocks as is and exchange the old mutual funds for new ones. Ideally, we would want the new holdings to be low-cost index funds. The problem is the account is a taxable account and exchanging any of the current mutual funds for a new one would generate capital gains. Although these would be taxed at the lower long-term rate, it’s still tax nonetheless. And nobody likes paying taxes. One option would be to exchange all the funds now into a low-cost, total market index fund and bite the bullet in terms of capital gains. Another option would be to exchange only the funds that have decreased in value and hold on to the funds that have had gains. This option sounds appealing as we could potentially reduce our taxable income by tax loss harvesting. However, this is easier said than done as the majority of the mutual funds have incomplete or missing cost basis information, so figuring out which funds have gains or losses would be a nightmare. Right now, Random Gal and I are leaning toward exchanging all of the funds in one fell swoop and just paying the capital gains tax up front.
Random Guy’s Final Thoughts
I hope you guys found this post useful and informative. I think it’s always helpful to review your finances regularly as you might come across something that could be costing you money, like high fees or tax-inefficient funds. At the very least, I hope this motivates you to get to some of the financial spring-cleaning that you’ve been putting off for later. Thanks for reading! Comments and thoughts appreciated!