A reader asked in my article (why we always recommend buying low cost index funds) what is considered a low cost index fund and I decided to share this on a separate post to give it more visibility as I’m sure more than one person will benefit from this.
Basically, I look at all the cost of owning an index fund vs buying all the stock the index holds without commission. These include –
Load – There are some funds that require a front end or back end load (essentially a fee for buying or selling the fund). If there is a load, I would not consider this as a low cost fund.
Expense Ratio – Every fund will need to have a team to maintain the paperwork, do the actual buying and selling of stocks if people cash in and out of the fund etc so there is always a fee the fund company charges to maintain the fund. Anything under 1% I would consider low cost but it will depend on the index. The best thing to do is to compare these with others that track the same index.
Commission – I also look at how I can purchase and sell these funds. For example, if my only option was to buy a fund using my ETrade brokerage account, it would cost me $20 per transaction. This is okay if I buy $10,000 dollars at a time (0.2% commission rate), but if I have automatic purchasing each month for my Roth IRA for the index fund at $20 per transaction, then I am paying a 6-7% commission rate, which doesn’t make sense at all.
I know that technically this shouldn’t be considered into the low cost vs non-low cost equation but all costs need to be calculated!
A very good option for low cost funds is the Vanguard funds because they have ultra low expense ratios and I think you can buy index funds with no commissions (please correct me if I’m wrong with this) if you have an account with them.
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{ 4 comments… read them below or add one }
Maybe it’s just me, but I don’t get why index funds have expense ratios at all.
The Vanguard 500 Index has $128 billion in assets and an expense ratio of 0.18%. Great huh? No! That means they’re spending over $230 million a year! And all they do is follow an index that somebody else put together. It’s a shame because I could do the same thing for just 0.09%
Give me a call Vanguard.
Jon: Actually, even though they have 128 billion in their fund, that is only a small portion of what the total market is. So the fund needs to sell and buy based what the total market does so that’s where the expenses are.
Guys, the expense ratio covers actual expenses, but also the fund’s profit. How else would they make money? 0.18% per year is completely reasonable for the service consumers receive and the responsibility fund managers bear.
Almost all Vanguard funds do not have loads (purchasing or selling fees that go to the company). However some index funds such as the Emerging Markets Index Fund have a 0.25% purchase and redemption fee. This fee, however, is not collected by the company, but goes back into the fund. The purpose is to discourage short term buying and selling.
So, if you are a short term investor, you can think of this fee as a load. If you are a long term investor, however, you will still pay the fee, but you will earn it back since other investors will also be paying these fees into the fund.