Costs Can Cripple Your Investment Returns

Almost everyone who reads Free Money Finance knows that I invest primarily in index funds. Yes, I have some stock and actively managed mutual funds (bought a long time ago -- I'm trying to weed them out without paying a ton in capital gains taxes), but almost all of my new investment money is going into index funds and has been for quite some time.

A key reason I like index funds is because their net return is better than most other alternatives. While the gross return of an index fund may actually be lower than other fund options, the net return of index funds are generally higher because the expenses associated with index funds are lower.

For example, let's say you have a stock index fund that earns 10.5% per year and has expenses of 0.2%. Your gross return is 10.5%, but what you take to the bank (so to speak) is 10.3% (10.5% - 0.2%). On the other hand, you may also own an actively managed mutual fund that returns 11.0%, but costs you 1.0%. In this case, your gross return is 11.0% but you end up earning a net return of only 10.0% (11.0% - 1.0%). So when all fees are taken out, the index fund delivers a better overall return.

Now some reading this might suggest that an extra return of 0.3% isn't really worth that much. But it is. For example, let's say you invest $5,000 a year for 30 years. Over this period of time and with this level of investment, the difference is almost $50,000. And that's with such a small amount of spread between the net returns. Now if the spread is more, obviously the difference goes up significantly.

Here's an example from Vanguard that illustrates this principle as well as details some of the costs you might face when investing in mutual funds. Expense ratios, sales charges, 12b-1 fees, trading costs. All of these can add up to significant amounts that hamper the performance of your investments. Index funds tend to minimize these fees, thus giving them an advantage in delivering an overall better return.

In conclusion, I wanted to share this from the Vanguard article. It recommends that investors look for funds with:

• Expense ratios of 0.50% or less.
• Turnover ratios of less than 50%.
• No sales charges.

For related posts, see these:

• Index Funds Continue to Be Great Investments

• Index Funds Save on Taxes

• The Top S&P 500 Index Funds -- I Own Them All (Almost)

Comments

[Edmund]

Sigh, somehow I have trouble getting the people around me understand how small fees can add up to big sums.

They want to focus on the big returns, not the small fees. They don't understand that investment return is uncertain, but fees are certain to take a chunk.

[Honest Dollar]

How do you feel about ETFs tracking the same indices versus mutual funds?

[FMF]

Honest Dollar --

Do you mean ETFs versus index mutual funds?

[Dave]

Edmund, do you invest in emerging market funds? I haven't found any that come without sales charges. As you may know, Vanguard's emerging market index fund does have a purchase/sale redemption fee.

[Honest Dollar]

Yes, I meant ETFs versus index funds that track the same indices. So would you prefer to invest in an S&P 500 ETF or an S&P 500 index fund (or total market ETF vs. total market index fund, or MSCI EAFE ETF vs. MSCI EAFE index fund, etc.)?

Your post inspired me to do some number-crunching on VTI versus VTSMX, the two total market products from Vanguard. The difference is pretty negligible if the ETF trades aren't commission-free. But I wanted to see your thoughts on the whole ETF vs. index fund debate.

[Becky]

I'm going to have to go against the grain on this one. It seems that everyone in personal finance blogs loves index funds, particularly Vanguard. I don't want to put a super-long post on here, so I will give minimal info and anyone is welcome to contact me if they want more details.
I plugged the Vanguard 500 Index Fund into a Morningstar calculator and compared it to American Funds Growth Fund of America A shares. I did a $20,000 initial investment so that the highest sales charge is charged at American Funds. Investment made at common start date of August 31, 1976 ends with a total value on October 31, 2007 of:
Vanguard: $730,954 (12.24% annual return)
American Funds: $2,136,754 (16.17% annual return)
I'll pay the sales charge and end up with $1.4 million dollars more after 31 years, thank you :)

[Edmund]

Becky,

It's nice that you can find a fund that beats Vanguard's index fund historically.

For the next thirty years, I am sure there is a fund out there that will outperform Vanguard's index fund.

However, are you trying to make a claim that this fund that has outperformed in the last 30 years will continue to do so for the next 30 years? You are still chasing fund's performance, regardless of whether or not you are looking at the past years, past 3 years, past 5 years, or past 30 years of return.

I can point to some guy who has won the lottery and said "hey buying the lottery is better than buying your index fund". Unless you know he is going to win again in the next thirty years, you should probably stick to index funds.

The reason for buying an index fund is not just based on past performance, but there is a lot of portfolio management theories that support it.

[Becky]

I agree that you can't buy funds based just on past performance, but you also shouldn't buy any old fund just because expenses are low. Go check American Funds out. Their expenses are among the lowest in the industry PLUS they have awesome performance. My point is just that Vanguard isn't the only good option out there and index funds aren't the only good option out there.

[Double Journey]

Becky, I'm a pretty active investor and the majority of my assets are not in index funds. I am mostly in individual stocks with a few mutual funds, most of which are actively managed.

That being said, for 90% of people out there, index funds are the way to go. Trading the way I do takes a lot of time and a lot of interest. Not something most people have. When you take into account that 80% of mutual funds don't beat their index in any given year, then you can see why Bogle is such a strong advocate of index funds.

You will always be able to find funds that beat the index, but at the same hindsight is always 20/20. Knowing which ones will do it going forward, that's the Million dollar question.

[FMF]

Becky --

I was going to respond to you, but it looks like Edmund and Double Journey took the words right out of my mouth. ;-)

[FMF]

Honest Dollar --

They both have advantages depending on how you buy. Read this and see if it answers your question:

http://www.freemoneyfinance.com/2007/03/which_is_better.html

[Lord]

I know people for whom even the overhead of indices is considered too much and prefer to own a diverse selection of underlying stocks directly.