Investment Costs Everywhere - Another Point for Index Funds

Here's a piece from MSN Money that asks if your retirement fund is leaking. Why would it be leaking? Because investing costs are eating away at it. Consider this:

In selecting mutual funds, most investors know to check the expense ratio, the standard measure of how much it costs to own a fund. U.S.-stock funds pay an average of 1.31% of assets each year to the portfolio manager and for other operating expenses, according to the fund experts at Morningstar.

But that's not the real bottom line. There are other costs, not reported in the expense ratio, related to the buying and selling of securities in the portfolio, and those expenses can make a fund two or three times as costly as advertised.

A study updated last year of thousands of U.S.-stock funds put the average trading costs at 1.44% of total assets, with an average of 0.14% in the bottom quintile and 2.96% in the top. Expenses are one of the most important things investors can look at, says study co-author Richard Evans, an assistant professor of finance at the University of Virginia's Darden School. "We find that our estimates of trading costs" are an important predictor of performance. While "some trading actually adds value," Evans says, high trading costs overall tend to have a negative impact on performance. On average, $1 in trading costs decreased net assets by 46 cents in this study.

What exactly are these costs? There are four main components: brokerage commissions, bid-ask spreads, opportunity costs and market-impact costs.

It certainly is hard to overcome a big cost disadvantage when investing. That 1% (or more) difference between the average actively managed fund and a decent index fund is HUGE -- especially when you're investing over several decades.

The cost advantage of index funds is one reason I like them so much. The index funds I use as my primary investments have expense ratios of 0.07%, 0.10%, and 0.27%. The Fidelity index fund I have my 401k invested in has an expense ratio of 0.07%. It takes a pretty good fund manager to overcome an almost 1.5% advantage that these funds have over an actively managed fund -- and that's why most don't beat index funds once expenses are accounted for. That's why I'm sticking with index funds all the way!!

Comments

[myfinancialobjectives]

wow .07%, that's really really good! I'm currently looking into Vanguard's S&P 500 Index fund which has an expense ratio of .15%, I thought That was good! I may have to keep looking!

[David]

You might also want to consider low cost ETF's. Fidelity offers zero commission for 25, low expense, well rounded ETFs from iShares. Bank of America and Wells Fargo also have zero commission plans available.

[Kevin's Free Money]

Thanks for the great advice. It's sad that most people who are in trouble like this wouldn't be able to access this useful information. Otherwise they'd not be in trouble.

[Old Limey]

It makes little sense to zero in on a fund's expenses. If you want your portfolio to have a good Performance why don't you rank funds by "Performance". That's what I did from 1992 until 2008 when my portfolio had reached a size where I no longer needed to live through the stress of market volatility and can be invested in CDs and Muni Bonds that have no annual expenses, have an average yield of 4.86% (tax deferred and tax exempt) and when held to maturity will even show some capital gains because the bonds were purchased at prices below par.

Of course if you don't have a database of funds that are subdivided into all of the various market sectors (domestic and international), of which there are many, and you don't have software that allows you to build and rank families of funds by a variety of statistical measures over many different time periods then you just as well carry on zeroing in on fund expenses rather than fund performance and suffer through retirement destroying decades like the last ten year period from 1/1/2000 to 1/1/2010 which was:

Annual Compound Rate of return
----------------------------------------
Nasdaq 100................... -6.66%
Nasdaq Composite ........ -5.67%
S&P500 ....................... -2.72%
US Total Stock Market ... -1.82%
Dow Jones Industrials ... -0.97%

[Robert Wasilewski]

I agree 100% with the gist of this article. Going with low cost index funds is the way to go for most investors and most can easily learn to rebalance their portfolios.
The problem is compounded when advisors take money and put their clients in high priced actively managed funds. Everybody in the chain is taking a cut.

[FMF]

myfinancialobjectives --

Click the link above. I get those rates because I invest in Admiral shares.

David --

I invest every month and, as such, would have higher trading costs if I invested in ETFs. And are their expense ratios below .07%?

Old Limey --

As you know, total return - expenses = net return. By talking about expenses, we are talking about return (net return in this case.)

In addition, I think you'll agree that the vast majority of people don't have the time, skill, or access to data/ability to use it to do what you did. You don't even think you could do it again these days, do you?

This is one reason why Warren Buffett recommends index funds for almost all investors.

[Dave]

FMF, the expense ratio for iShares IVV (an S&P 500 etf) is 0.9%. Not 0.7% but pretty close and still very low.

Regarding trading costs, as I said in my original comment, several sites offer ZERO commission (i.e., 0 trading costs) for this and other ETFs. Check out Fidelity, Bank of America, and Wells Fargo, among others.

[FMF]

Dave --

Ok, so what would be the difference between the two? (Why would I want to change?)

[The Biz of Life]

Does your manager have enough talent at picking stocks/bonds to make up for the expense differences between the index and their fund? That difference could be anywhere from .5% to over 2%. 2% is a lot of outperformance for any manager to sustain year after year. The funds that do outperform for a short period of time tend to suffer from asset bloat as investors pile in and become more like index funds. So yes, cost matter a lot, and they compound negatively to work against the investor's total returns. Unless you like buying yachts and vacation houses for the mutual fund execs, indexes are about as low cost as you can get.

[The Biz of Life]

Here is one of my favorite quotes:

“For professional investors like myself, a sense of humor is essential. We are very aware that we are competing not only against the market averages but also against one another. It’s an intense rivalry. We are each claiming, ‘The stocks in my fund today will perform better than what you own in your fund.’ That implies we think we can predict the future, which is the occupation of charlatans. If you believe you or anyone else has a system that can predict the future of the stock market, the joke is on you.”
~ Ralph Wanger, former manager of the Liberty Acorn Fund

[Paul]

I don't know about everybody else's 401K (or 403B, like I have), but my company does not offer index funds as an option, so I am at the mercy of the more expensive actively managed funds. I wonder if my company was encouraged by Fidelity, T Rowe Price, etc to not allow an index fund option?

[FMF]

Paul --

You could suggest they add the option -- I know Fidelity, etc. offer those type of funds.

[Tyler]

“In addition, I think you'll agree that the vast majority of people don't have the time, skill, or access to data/ability to use it to do what you did. You don't even think you could do it again these days, do you?” –FMF

I would strongly disagree. There is a wealth of free or very low cost data out there. Claiming a lack of data is just false. Lack of time? Make time. Lack of Skill? Well ok nothing I can do here. Old Limey has stated before that the advantage he once had has faded, but his specific strategy wasn’t exactly the point- absolute returns at a certain risk level are the most important.

I always took 50% of profits above a defined risk-free rate. All costs were passed to investors. Without any context, that is insanely expensive. The volatility adjusted returns, after fees, matter a lot. Although fund costs are important, over focus on them can be incredibly costly to a portfolios returns.

It’s pretty much impossible for you to figure out a funds market impact- the index funds have a ton of market impact by the way. Check out the roll with USO (they have gotten better, but it was huge a year ago and it was costly to investors in that index). Most index funds don’t care that much about market impact. They care about tracking the index and keeping costs low more than anything else- regardless of their impact on the index they are trying to track. I’ve seen index orderflow and its shocking how dumb it can be. (but again, you as the investor are paying them to match the index, not buy the underlying stocks intelligently.)

Using averages is always dangerous because of what it can hide. So be careful when looking at the ‘average actively managed fund’.

Indexing is fine if one understands the pitfalls and believes the advantages outweigh the disadvantages. Wall Street is not the friend of the small investor. Anyone of any value- fund managers, financial advisors, etc- won’t touch you unless you have a large net worth. When you are good, you can pick and choose what money you take.

Wanger quote- One doesn’t need to predict the future to beat the market. The skill isn’t in predicting, the skill is taking risks that has above market payouts for their risk levels. Taking a position with 5% risk and 20% payout over a positions that has 5% risk and 10% payout. This obsession with ‘predict the future’ is just the wrong way to look at things.

[Nate]

My company uses Fidelity -- but the index is not an option. However they have several very well performing active management funds at 1% expense. I can't complain.

[Tyler]

Paul-

I'm not an expert, but for 401k programs the more options and they type of options increase or decrease the cost of the program. Adding more options or adding index funds of a certain type, might drastically change the cost of the program to your company. It's rarely as simple as 'just add it'.

[Old Limey]

FMF
I admit that that the investment techniques that I used upon retirement would have not been possible for me to use while I was fully employed in a career that consumed nearly all of my time. As you point out, they would not be suitable for everyone even in retirement. First you need to have very good mathematical skills, then you need a comprehensive database that is updated daily. The one I still get updates for daily now has almost 10,000 funds and indexes divided up into 661 fund families. You then need excellent computer skills, some comprehensive analysis and ranking software, lots of time, and to build up a lot of experience - and experience is only gained the hard way by making mistakes and learning from them. It also involves a considerable amount of trading, even more now than in the old days when everything, including news, moved a lot slower. As for thinking that anyone can predict the future - that's a ridiculous statement - what is a true statement however is "The Trend is your Friend". You follow upward trends until they change, when they change you switch into something else, if there's nothing else trending up then you stay out.

The second major difference between then and now is the market. The market used to be rational and its actions were the result of decisions by millions of investors. Now, in my opinion and that of many experts, the market behaves irrationally and is highly influenced by a few large investment banks that are able to borrow unlimited funds from the Federal Reserve at almost no cost and to invest it using computerized tradings systems and massive computer capabilities that place small investors at a great disadvantage. Those large investment banks now account for the lion's share of the trading.

[Tyler]

Old Limey- Ironically, indexing/index funds are a major factor in your second paragraphs observations. Algos are a lot cheaper at filling orders than a human and thus a preferred method of filling index fund orders. Index funds dont care about valuation or price.

[billyjobob]

Nate ... My 403 is mostly invested in Fidelity's Spartan 500 index ( FUSEX )
Why can't you invest in that? It's an index.

[FMF]

Tyler --

Ok, so what are you saying exactly? I'm not sure...

[Tyler]

1. absolute returns matter. expenses are important but some focus on them too much.
2. Market impact, spreads, execution of the strategy is a very important expense, but not something an investor will ever really be able to analyze.
3. there is plenty of data out there for anyone who wants to look at it. Lack of info is not really an excuse anymore.
4. Looking at averages is easy but dangerous. "the avg money manager does X" can be misleading.
5. Indexing isn't all bad. If that's the style that fits your unique situation best. Index funds are not always a good thing and the managers of said funds are not motivated by returns.

[FMF]

Tyler --

Ok, can't say I disagree with any of those...

[Old Limey]

Tyler:
I assume that "Algos" is an abbreviation for "Computer Algorithms". That abbreviation wasn't used when I was in the workforce.

You are absolutely right that there is plenty of market data out there that is free, however there are several problems with it.
One problem is that almost none of it is adjusted for dividends and year end distributions which are significant for both bond and equity funds.
The other problem is that in order to make comparisons of all the funds in a particular sector or category you need to have all of those funds grouped into a fund family so that your software can analyze the family over whatever time period you specify and then be able to rank them by various measures of performance and volatility. When you have that kind of capability on your computer you can then bring your judgement and experience to bear by ranking over a variety of time periods that would include maybe the last month, the last 2 months, a good year in the market, a bad year in the market etc. etc. It takes quite a bit of time to start with several hundred funds and gradually winnow them down to a small number for the next phase. The next phase would shift away from looking at tables of numbers to viewing charts of up to half a dozen funds on the same screen, again using different time periods. Finally the last step would be to read the on-line prospectus and examine the fund's holdings, the fund size, the fund manager, any special fees or restrictions, and lastly the fund expenses.

At least with this approach you are making a valiant attempt to perform some intelligent fund selection.
The other part of the investment strategy is concerned with timing the funds that you have selected. There are many different techniques for timing a fund, such as a moving average, a crossover of two moving averages, MACD, RSI, Stochastics, RSI-Price divergence or often a combination of techniques. Different investors use different methods. Also one method often works better on low volatility funds, another works better on volatile funds. That's where one's years of experience come in. By timing I don't mean short term trading, I mean generally a holding period of several months.
In conjunction with fund selection and fund timing there is also analysis of the NYSE and Nasdaq market indexes that helps to judge market health. Here, measures such as the summations of advances-declines, up-down volume, new highs-new lows, and the McClellan Oscillators and Summations paint a good picture of market health.

On the other hand by using index funds, you are greatly reducing the impact of your skills, experience and judgement and relying on the longterm performance of the market and the economy.

The few 401K plans that I have any knowledge of don't offer very many choices. The problem with that is that for a great many investors (including me when I retired) the bulk of their portfolio is in a 401K and you don't obtain absolute control of it until you retire and roll it over into an IRA. Now, after 18 years of retirement and 5 years of mandatory IRA distributions our taxable and IRA accounts are almost equal in size.

[David]

FMF,

For long term investors, ETFs offer tax advantages over index funds. Also, since they're traded like a stock, the price you pay for the ETF is determined instantaneously rather than having to wait for the NAV price at the end of the day. For more active investors like myself, there are simply more choices in ETFs than index funds. For instance, it's difficult to find an index fund for shorting the S&P 500. There are several such ETFs.

I'm not saying that ETFs are right or wrong for you. There are disadvantages to both. But as someone maintaining a blog like this, I think it makes sense for you to be an expert in ETFs rather than just blowing them off. (Similarly, you should become an expert and keep an open mind of the pros and cons of Vanguard/Bogle-type long term buy and hold strategies versus other investing strategies.) They've been around since the early 1990s and are here to stay. You should be savvy about the investment choices there are out there for everyday investors.

http://www.investopedia.com/articles/mutualfund/05/060605.asp

[FMF]

David --

I'm not blowing anything off. I'm asking questions to try and learn more to see what's a better option for me. And I do have an open mind. What makes you think I don't?

As far as being an expert goes, I never claimed to be one and do not aspire to be one. I am simply a person managing his money, telling what I do/think, and letting others comment/decide for themselves what they should do.

As for results, I'll let my net worth speak for itself. I've talked about it in bits and pieces and if you've been reading closely you know where it stands.

I'm not saying any of this to brag or to start an argument, just staing my position. It's hard to tell someone's tone in a comment, but yours seems somewhat hostile/accusing (for whatever reason). Maybe it isn't and I've just read it incorrectly. Either way, I wanted to respond and let you know that I'm always looking to grow/learn and was only asking you questions because of that fact.

[Dave]

FMF,

Thanks. It is difficult to tell someone's tone in these comments. My take was that your comments above were somewhat hostile. Your terse, one line responses didn't seem to be putting much thought into the ETF thread. For instance, just after I had discussed zero commission accounts, you stated that by investing every month you would have higher trading costs. Thus to me, it suggested like you were blowing this idea off or at least somewhat tone deaf to the very idea I had explained. Even if you have no interest in becoming an "expert," all I'm saying is it would benefit you to be well rounded when it comes to managing money.

The larger point is that you seem to be hostile toward any investment management technique beyond buy and hold. This Vanguard/Bogle-style technique was successful from 1982 to about 1999 (perhaps your formidable learning years?) but there have been multi-decade periods when this technique was not successful. Even if you think this is the best way, it's certainly not the only way, and you may want to consider being more open minded about other ways of investing, as some of these comments above suggest.

[FMF]

Dave --

Uh, thanks. I think.

Exactly what am I not being open minded about?

[Dave]

FMF,

Look, I don't want to get into an argument with you. I should add that for the most part I appreciate and enjoy your blog and find it thoughtful. I said exactly and in detail why I thought you were blowing off and being hostile. You're welcome to agree or disagree with me. I'm not looking for an apology but, like you yourself said, I wanted to respond.

As for what you're not being open minded about, I already said it specifically -- investing styles other than the Vanguard/Bogle "buy and hold" approach. I don't know how I can be any clearer. If you take a step back and look at the larger picture, I don't think it's that unreasonable to suggest that generally speaking you strongly favor this type of investing style over others. I'm NOT saying that you haven't had blog posts here and there referring to other investing styles. And I'm certainly not going to go through all of your historical posts to do a detailed, line by line analysis of every time you mentioned one style or the other. But in my opinion, I think you're view is that Bogle buy and hold is the best, and you are less willing to consider, invest time to study, or personally apply other styles of investing. It's as simple as that. No reason to get defensive about it.

[Old Limey]

@David and FMF

There is really nothing to argue about between mutual funds and ETFs in the case of mutual funds and ETFs that track a popular market index. Here's a case in point:

IVV is Barclay's I shares ETF that tracks the S&P 500. --- Expense currently 0.09%. Size $21.85B.
VFINX is Vanguard's mutual fund that tracks the S&P 500. Expense currently 0.16%. Size $92.6B.

The charts, adjusted for all dividends, are almost indistinguishable.
The only difference is that Vanguard's fund has been in existence from the beginning of my database which is 9/1/88 whereas the ETF fund has only been in existence since 5/19/2000.

[FMF]

Dave --

Ok, then we just disagree, I guess. You mentioned, twice, that you thought I was close-minded. I don't think I'm being closed-minded. In fact, I asked questions to get more info, so if that's closed-minded...

Old Limey --

That's what I'm concluding -- there's not much difference. The only difference from what you have above is that my shares are less expensive because they are Admiral shares. Plus having a small number of funds concentrated in one account at one company suits my investing style. ;-)

[Old Limey]

FMF
Vanguards Admiral S&P500 fund does outperform both their VFINX fund and Barclay's Ishare fund.
2/27/09 - 3/18/10
VFIAX 62.48%
VFINX 62.29%
IVV 61.81%

The Admiral fund VFIAX, as you must know, is sold through investment advisors, has a very significant upfront load fee of 5.26% and requires a minimum investment of $100,000.
I hope you didn't pay that load fee, if you did then it destroys your argument about fund expenses being meaningful because 5.26% of your principal would go into your advisor's pocket when you made your purchase.

[HollyEE]

Can I request that Old Limey (and Tyler?) consider writing a guest post about your analysis techniques? I'm a definite nerd, but have to admit I have not used MACD, RSI, Stochastics, or RSI-Price divergence. But you're making me think Matlab and I should be having a lot more fun! I'd love a good discussion of statistical methods for making investment decisions. (If you have favorite books/websites, I'd love to know those as well. I am a bit fan of The Intelligent Asset Allocator with his discussion of standard deviation and risk based returns).

[Old Limey]

HollyEE
I feel that subject would be inappropriate for this forum, where typical postings are only a dozen lines, or even less. There are many books available on technical analysis of stock trends.
The manual that I wrote for my (now off the market) software was 300 pages and it only covered the usage of the tools provided.
I believe that Tyler is either a broker or an investment advisor and I am a retired engineer. Topics on this forum tend to only last a little over a week and what you are suggesting would be a huge topic that could go on indefinitely and probably not be of broad interest.

[mysticaltyger]

It's hard to argue against index funds. They are a decent way to go. But they're not the ONLY way.

I agree with Tyler. Costs are important. But they're not everything.

There are plently of mutual funds out there that have consistently beat the S&P 500 over the medium and long term that charge reasonble fees, even if they are higher than those of index funds.

Not too long ago on another post I listed a bunch of funds that have matched or beat the S&P 500 over the medum & long term.

Here's that list again for those of you who missed it:

Almost any stock or balanced fund from American Funds (provided you don't have to pay the sales load and that the shares are "A" or "R4" or "R5" or "R6" share classes.

PRWCX T. Rowe Price Capital Appreication
OAKBX Oakmark Equity and Income
DODGX Dodge & Cox Stock
VWELX Vanguard Wellington
DODBX Dodge and Cox Balanced
MAPOX Mairs and Power Balanced
MPGFX Mairs and Power Growth
FBALX Fideltiy Balanced

ACEIX Van Kampen Equity and Income (as long as you don't have to pay the sales load)

I'm sure there are others, but these are the ones I can remember off the top of my head.

[mysticaltyger]

I thought of a few more funds that have consistently beat the S&P 500:

PRBLX Parnassus Equity Income
PRFDX T. Rowe Price Equity Income
VGSTX Vanguard Star
TWEIX American Century Equity Income

[Old Limey]

@mysticaltyger
I ranked the funds that you mentioned over the last 10 years.
PRWCX was at the top with ANN=+10.04%
OAKBX was second with ANN=+10.01%
VFINX was at the bottom with ANN=-0.59%

$10,000 over ten years would have grown to $16,077 in PRWCX
$10,000 over ten years would have grown to $16,040 in OAKBX
$10,000 over ten years would have shrunk to $9,425 in VFINX, Vanguard's S&P500 fund.

I agree with you 100% about market index funds.

[Old Limey]

There was an error in my prior post - here is the corrected version.

@mysticaltyger
I ranked the funds that you mentioned over the last 10 years.
PRWCX was at the top with ANN=+10.04%
OAKBX was second with ANN=+10.01%
VFINX was at the bottom with ANN=-0.59%

$10,000 over ten years would have grown to $26,031 in PRWCX
$10,000 over ten years would have grown to $25,961 in OAKBX
$10,000 over ten years would have shrunk to $9,425 in VFINX, Vanguard's S&P500 fund.

I agree with you 100% about market index funds.

[mysticaltyger]

Thanks for the extra info., Old Limey! I knew the returns were way better than the S&P 500 averages...just didn't feel like posting all that.

The 15 year returns for all of the funds listed are also better. I checked via Morningstar.com web site.

[FMF]

Ah, yes. It's always easy to find better investment options looking in hindsight. But the problem is, what are the best options for the NEXT 10 years? :-)

[D]

@Old Limey

If you were in this market today and had little experience investing would you invest in index funds or would you go another route?