LAST REVIEWED Apr 23 2020 9 MIN READ
By Damian Davila
Hoping that a recent high-performing mutual fund repeats its feat in the future or that a bet on short-term market news, such as Brexit, pays off, managers and financial advisers of active funds regularly pitch individual investors to jump on and off from investments. However, studies have shown that between 67% and 97% of mutual funds get beaten by index funds.
What is an expense ratio?
An expense ratio is the percentage of a given fund that is charged for management, administration, and operation costs. Practically speaking, it’s the fee a fund will charge you for investing in it and is usually deducted automatically from your account.
It’s important to keep a close eye on these numbers because it turns out that the only dependable indicator of future performance of an investment is its expense ratio. Legendary investor Peter Lynch said it best, “In the long run, it’s not just how much money you make that will determine your future prosperity. It’s how much of that money you put to work by saving it and investing it”. Let’s review some example scenarios that show how much money you can lose over time just based on bad expense ratios.
The lower your investment expense ratio, the better your investment returns
While this investment maxim is universally accepted, most people believe that negligible differences aren’t a big deal. Consider the two following examples:
|Fund A||Fund B|
|Starting balance: $10,000||Starting balance: $10,000|
|Average Annual Return: 4.5%||Average Annual Return: 5%|
|Annual Expense Ratio: 1.5%||Annual Expense Ratio: 2.1%|
|Balance after 10 years: $13,439.16||Balance after 10 years: $13,309.26|
|Balance after 35 years: $28,138.62||Balance after 35 years: $27,198.07|
Since a 5% average annual return sounds much better than one at 4.5%, some investors would argue that Fund B’s higher annual expense ratio is justified. However, let’s look at what happens if we were to hold the two investments for a 10-year period. At the end of the 10-year period, Fund A and Fund B would have balances of $13,439.16 and $13,309.26, respectively.
The longer your holding period, the greater the negative impact of higher expense ratios on your nest egg. At the end of a 35-year period, Fund A and Fund B would have balances of $28,138.62 and $27,198.07, respectively. In the end, chasing the “higher performer” would cost you $940.55 over a 35-year period!
Index funds are the leaders in low expense ratios
Index funds are passively managed funds that track components of a market index, such as the S&P 500 or the Russell 2,000. The main advantages of index funds are broad market exposure, low operating cost, and low portfolio turnover. Over a 20-year period, stock mutual funds underperformed the Vanguard S&P 500 index fund by an average of 2.1%.
A lower expense ratio is the key to success when it comes to index funds. According to data from the Investment Company Institute, in 2015 the average expense ratios of actively managed equity funds and index equity funds were 0.84% and 0.11%, respectively. Holding a $50,000 investment on an actively managed equity fund would have cost you $365 more, meaning that your investment would need to provide an extra 0.73% in return just to cover that difference.
Index funds are better suited than equity-exchange traded funds for 401(k) plans
Let’s review some options if you were looking to invest in an index fund or equity-exchange traded (ETF) fund tracking the S&P 500:
|Index Fund||Symbol||Minimum to Invest||Expense Ratio|
|Fidelity Index Fund – Premium Class||FUSX||$10,000||0.045%|
|Vanguard 500 Index Admiral||VFIAX||$10,000||0.05%|
|iShares Core S&P 500 ETF||IVV||0.07%|
|Fidelity 500 Index Fund – Investor Class||FUSEX||$12,500||0.09%|
|Vanguard 500 Index Fund – Investor Class||VFINX||$3,000||0.16%|
At first look, it would appear that the lack of minimum investment requirements to purchase ETFs would make them more appropriate for 401(k) plans. However, the expense structure of ETFs makes it difficult to keep track of the actual cost of ETFs in a 401(k). This is why index funds are better suited for 401(k) accounts.
Of course, in order to achieve the lowest possible investment expense, you would need to meet the minimum purchase requirements. Fortunately, there is an easy way to get around those requirements. By starting a 401(k) account or rolling over an existing one to Human Interest, you get access to all low-cost Vanguard index funds from every asset class and risk category, including those in the Admiral class.
Through Human Interest, you can effectively invest in Vanguard Admiral class index funds, such as the Vanguard Small-Cap Growth Index Admiral (VSGAX) and the Vanguard Growth Index Admiral (VIGAX), without the $10,000 minimum investment requirement. Besides index funds in U.S. equities, you’ll also have the ability to invest in Vanguard Admiral class index funds in international equities, real estate, and bonds.
Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers
This is coming from a man that has been directly, and nowadays indirectly, responsible for keeping a 20.8% compounded annual gain for the 1965-2015 period!
The bottom line: Look for good (low) expense ratios!
Chasing high-performing actively managed funds not only costs you more in fees but also doesn’t guarantee high returns in the future. Studies have shown that the rare mutual fund that beat its benchmark in one period is unlikely to do so again in subsequent periods. By investing in low-cost index funds, such as the ones from Vanguard, in your 401(k), you’ll improve your chances of reaching your nest egg goal.
Human Interest works with startups to help their employees save with a great, scalable 401(k). Click here to learn more.
Related article: Are My 401(k) Fees Too High?
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.