How High Mutual Fund Fees Can Cost You Millions (Another Reason You Should Love Index Funds)

As many of you know, I'm a fan of index fund investing. One of the reasons I like index funds is that they have a great track record of good, solid investment returns. Much of these great results are driven by the fact that index funds have very low expenses. And, as we know, low costs mean higher returns (also see Expenses, Taxes and Size Matter in Choosing Bond Funds (And Stocks too!) and The Advantages of Index Funds for more information.)

I found an example of how much expenses can impact your investment returns and it's pretty significant. Check out this paragraph:

If Vanguard’s 0.18% fee is low and the category average is 1.27% you can bet that some funds are as far above the average as Vanguard is below the average. A fund with an expense ratio as high as 2.36% will cost $11.2 million dollars more over 50 years than the Vanguard fund. Instead of a $16.8 million dollar portfolio with a low fee structure, your investment will only grow to $5.6 million dollars because of the higher fund fees. Add a sales load on the front and you will be left with $5.1 million dollars. The $11.7 million that was lost to fees and forgone earnings are hidden expenses that are usually not perceptible as they are happening, but extrapolated over time they are huge.

They certainly are huge! And while most of you reading this post aren't investing in funds with a 2.36% expense ratio (at least I hope you aren't), you may have total investment expenses that average 2.36% (for instance, you use a planner who charges 1% of assets and he buys a fund for you with an expense ratio of 1.36%). Or even if your total expenses are "only" the average 1.27% -- that's still a large number compared to many other alternatives and you could be losing millions throughout your investing career.

Of course, you want to maximize total return, so an investment with a 2% expense ratio that has a return of 15% is better than an investment with a 0.2% expense ratio and a 10% return. The problem is, it's hard to find a mutual fund investment that consistently earns a high enough return to justify a big expense ratio.

Or think of it this way -- one investment starts out with 1% less in built-in costs than another. The one with higher expenses is at a disadvantage from the get-go -- you're down 1% before you even get out of the gate.

It's figures like these that keep me investing in index funds.

Comments

[Russell Bailyn]

Great points... index investing all the way! An investor can go even cheaper than Vanguard (or other no-load mutual funds) with a good ETF. The Spider ETF (.09 expense ratio)is still half the price of the Vanugard 500 Index Fund (.18 expense ratio) and distributes lower capital gains. The only potential problem with that is you might have to pay a commission to a broker to buy the ETF. If you can find a cheap online broker this might truly minimize your costs!

[FMF]

Russell -- My main issue is that I dollar cost average by buying more shares every month. An ETF gets expensive in commissions when someone buys this frequently.

[Lazy Man and Money]

Zecco.com and Bank of America will help make ETFs easier to invest in. Saving those commissions will allow you to rebalance a lot easier as well. I've been using ETFs for my yearly Roth IRA, putting 4K to work with just a $10 commissions.

[FMF]

Yes, but even at $10 a trade, it's too expensive for me. I invest $1,000 per month (every month), so $10 for each trade is a 1% charge off the top.

[Lazy Man and Money]

Fair enough, mutual funds are the way to go. Either that or save up a couple of months and give Zecco a shot. I personally want to wait 4-6 months anyway to see how it goes for other people.

[Russell Bailyn]

Better to get started on Zecco sooner than later. I've seen other online brokers try to offer free trades- it usually lasts a year while they attract new dollars. Then they pull it away and start charging money like everybody else. Watch out for the "change of service terms" disclosure. It wasn't until a few years ago that I actually started reading those.

[esquire415]

It has been a year since Russell posted that comment. He was right. Scottrade and FirstTrade has stopped offering free trades with mutual funds. They now cost $17 and $10 respectively. October this year, almost 1 year since Russell's post, Zecco announced that it will no longer offer 40 free trades a month ($3.50 over that). Starting November 2007 (January 1, 2008 for existing customers), in order for you to get free trades, you have to have $2500 in your account or they will charge you $4.50 per trade if you have less than that or your balance (equity) goes below that. The free trades has been drastically reduced to only $10 free trades a month. Believe me, i'm pissed (and about 95% of Zecco customers). I hesitated to change brokers before because of their requirement of $2500 minimum but they changed it to $0 minimum $0 trades so I transferred my account. And they were clear in their ad that it was "not an introductory offer". I'm sure I wasn't the only one who was lured to this unscrupulous businees practice of theirs. It was a bait and switch. Now if you want to get out, they will charge you $50 to transfer your account.

They also changed their policy on IRAs. They now charge $30 custodial fee which was once free. Yes, not $10, not $20 but $30. That's quite a drastic change too. Trading mutual funds with them is also not free. Whatever happened to ZEro Commision COsts? They should rename their company AZECCO for Almost ZEro Commision COsts. However, if you mainly invest in ETF or Index Funds...Zecco is still cheaper.

If you are holding an IRA, you can beat the system (I think). Open an IRA account with Zecco. Buy all the ETFs or Index Funds you need, then transfer the account to ThinkorSwim. TOS will shoulder the $50 transfer fee that Zecco will charge you (you also avoid the annual $30 custodial fee). TOS offer 3 free mutual fund trades per month and also no maintenance fees. A year later, if you need to make changes to your account, you can transfer back to Zecco and do the process all over again. It's quite a bit of work but you avoid fees.