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.
Conclusions
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.
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{ 7 comments… read them below or add one }
Excellent post. Very interesting and it help me later. I am sure.
Yes, costs matter. However, performance matters more.
I am a fan of ETF’s and index funds….but performance numbers net the costs out. On an absolute basis, I rarely see ETF’s outperform the best funds.
Hi Neal. You’re right on both counts:
1. Performance is, of course, what we’re shooting for.
2. Performance numbers are shown on an after-cost basis.
So let’s ask the real question. Going forward, which would you wager on as a better predictor of future performance: A low cost structure, or a high long-term performance record?
(I’m curious to hear everybody’s thoughts here, so please chime in!)
Great, easy to understand analysis!
I think you would have to be crazy to invest in a managed fund. The rate of return on C is 7%. After inflation and taxes, you would actually lose money. Besides that, what managed fund outperforms the market over 30 years? None.
There are some other big problems of investing in funds, including index funds. The rate of return for C is 9% (due to low fees), but inflation and taxes are going to eat up most of that.
The real cost is the opportunity cost. That $10,000 could be put into another investment that would could start you on the path to being rich…
Excellent summation on the net effects of investment expense and the total drag it has on returns. While one reader has commented he has rarely seen many ETF’s out perform strong mutual fund managers I would submit that through diversification and negatively correlating your assets (Modern Portfolio Theory) your portfolio should perform better over time. I agree that if you are only buying one index fund (like the S&P500) you will have one volatile ride during this recession versus buying a highly diversified money manager. Unfortunately many of those managers have exceeded losses in excess of 45%.
This is why I loved Daniel Solin’s “The Smartest Investment Book You’ll Ever Read.” That was his main point about investments – pick the index fund with the lowest expense ratio so that you get to keep your money.
Nice post OI. In order to avoid fees I keep most of my retirement savings in CDs or index funds.