The impact of investment costs is never emphasized enough. In order to see how much it affects mutual funds returns, let’s compare a few different domestic stock mutual funds:
- Fund A: Vanguard’s Total Stock Market Index charges no sales load and has an annual expense ratio of 0.15%.
- Fund B: American Funds’ Investment Company of America charges a 5.75% sales load and has an annual expense ratio of 0.59%.
- Fund C: BlackRock’s Focus Growth Fund charges no sales load and has an annual expense ratio of 2.03%.
In other words, Fund A is no-load, with low costs. Fund B does charge a sales load, but it has fairly low annual costs. And Fund C charges no sales load, but it has substantially higher annual costs.
Now let’s imagine for a moment that over the next 30 years the market earns a 9% annual rate of return. Let’s also assume that both of the actively-managed funds (B and C) end up being exactly average. That is, their before-expense returns over the period are equal to the market return.
Let’s take a look and see how this would play out over an investor’s lifetime.
After the first year, Fund B is of course lower due to the sales load. But they’re all fairly close at this point.
After just 5 years, Fund B–despite its hefty sales load–has already overtaken Fund C due to its lower annual expenses. And Fund A is starting to pull ahead significantly.
After 10 years, it’s more of the same. Fund A’s lead continues to widen, and Fund C falls farther behind. By this point, an investor in Fund A will actually have 10% more money than an investor in Fund B and almost 20% more than an investor in Fund C.
Look at that difference. On a $10,000 initial investment, you will have paid an extra $50,000 over 30 years for the high-cost fund. An investor in Fund A would have almost 70% more money than an investor in Fund C.
First: Costs matter. A 2% annual expense may seem small. But over an extended period of time, it can absolutely crush your returns.
Second: Paying a sales load obviously doesn’t help your results, but for long-term investors, annual expenses have a far greater impact.
Third: If you do decide to invest in actively-managed funds, your chances of finding one that outperforms the market will be dramatically increased if you make sure to select a fund with low annual costs. Before investing in a fund, take the time to read the fund’s prospectus and check precisely what fees you would be paying.
(Fair warning: Even if you do search for low cost funds, your chances of beating an index fund are still probably below 50%.)
The following is a guest post from Mike at The Oblivious Investor. If you like it, you may want to subscribe to his blog for free daily updates.