It's been awhile since I've harped on investing expenses and how they rob you of your hard earned money. So when I ran into this article from MSN Money on why fund costs matter so much, I knew I had to share it with you all.
The piece starts out with a tongue-in-cheek comment that I love:
High-cost funds can be a great investment in the same way that a winning lottery ticket can. But high expense ratios are risk factors for eventual fund failure.
;-)
Here's an overview:
To borrow from Woody Hayes, the late great football coach at Ohio State, when you buy a high-cost fund, three things can happen, and two of those are bad.
First, you can get good performance. Second, you can get underperformance. Third, the fund can perform poorly and then get merged away.
Yet, some people insist that costs aren't important -- because they remember only the first outcome. And, to be sure, there will always be some funds that manage to overcome high costs and outperform their peer group.
And a few more details:
All things being equal, funds with high costs are much more likely to produce poor performance because of their cost disadvantage. However, all things aren't equal and most high-cost funds also have weaker management, higher risk strategies and fewer resources.
Put that all together and you have a recipe for failure. When a fund comes out of the gate with a few years of bad performance, the fund company, realizing that it will have an awfully hard time attracting assets, kills it off.
They also discuss index funds and have the following thoughts:
Does this mean that all index funds are superior to all actively managed funds? No. There are high-cost index funds, too. If we asked how the average index fund fared against the lowest-cost actively managed fund, you'd likely see that most index funds lag the cheapest actively managed fund.
I'd be wary of drawing too broad a conclusion, such as that indexing is always better than active management, because the above compared the cheapest index fund against all active funds. Of course you can improve your odds by focusing on low-cost funds, whether choosing actively managed funds or index funds. Both types have higher-cost funds with low chances of success.
And some final thoughts worth considering:
Sure, there will always be exceptions. Winning lottery tickets are great investments; the catch is that you have no way of knowing if yours will be a winner, and they are bad investments for 99.9% of people.
From a fund company's perspective, high-cost funds are like free lottery tickets because it has persuaded investors to pay the bill. If the fund company is lucky, it'll produce big enough returns to attract large sums of money. If it isn't, it'll simply fold up the fund and hide its mistake under the rug. Of course, that doesn't make the fund's investors' losses any less real.
Rather than making a bad gamble, the savvy investor should look for low-cost funds with sound fundamentals. Simply doing that will double or triple your chances of success and greatly reduce your chances of dramatic underperformance.
Here are my thoughts on the issue:
1. Cost certainly matter if you want to maximize your investment returns. Costs include ALL costs -- fees, expense ratios, taxes, etc.
2. This is one reason I invest in low-cost index funds. In particular, I use Vanguard (taxable account as well as 401ks rolled over into IRAs) and Fidelity (current 401k) index funds. Both companies offer very inexpensive index funds -- just the sort that the MSN Money piece recommends as great investments.
I totally agree with you. I use low cost index funds as well so that the charges are minimal as no fund manager is being paid. As far as I can tell the returns are the same on average as managed accounts if you take the costs into account.
Posted by: Rachel @ Master Your Card | April 24, 2008 at 02:55 PM