By Doug Carey
The era of high-cost, high-turnover mutual funds is slowly coming to a close. This cannot happen soon enough for investors who have seen much of their savings eaten up by mutual fund expenses, trading commissions, and taxes due to high turnover. It has been shown time and time again in research studies that low-cost index funds on average always outperform actively managed, high-cost funds. With so many choices out there today and the ease of trading platforms, there really is no excuse for paying the high fees associated with many actively managed funds.
Just last year, Vanguard, the pioneer in low-cost index funds, reduced the expense ratio on their S&P 500 Exchange Traded Fund (ETF) to an unimaginably low 0.06%. How they make money on this fund is hard to understand, but it is an absolute gift to those who want exposure to U.S. stocks.
The typical actively managed U.S. mutual fund charges about 1.5% per year in expenses. On top of that, there is constant turnover as portfolio managers trade in and out of stocks. This means capital gains taxes for any holdings that are sold at a gain. So on top of the 1.5% annual expense, investors are paying higher taxes and also get dinged on the bid/ask spread for all of the trades that take place inside the fund. The bid/ask spread means the fund pays more for the stock than they can sell it for at that moment. This compensates exchanges which make markets in stocks.
Index funds rarely pay capital gains taxes and have very low turnover because the goal of these types of funds is to simply mirror a relatively static index, such as the S&P 500. Trades are only made when the constituents of the indexes change, which does not happen very often.
It is a simple exercise to compare high-cost funds vs. low-cost funds over time. I ran a comparison of the Vanguard S&P 500 ETF vs. the typical mutual fund that charges 1.5% in fees. I assumed an 8% annual return for 30 years for each fund. We see the results in the chart below.
Starting with an initial investment of $10,000 the investor will have slightly over $90,000 using the Vanguard ETF. Using the actively managed fund, the total amount will be only a little more than $60,000. This is a 48% difference in the total amount of money at the end of 30 years and all simply due to a difference in expenses. Also note that this does not take into account the higher tax bill in the higher-cost fund due to its turnover. With this taken into account, the difference in the investment values would be even larger.
Studies have shown that due to the higher expenses and higher tax bill, actively managed funds on average would have to outperform index funds by 4.3% each year just to break even with them. Of the 452 equity mutual funds that have existed in the Morningstar database for at least 20 years, only 13 have outperformed the S&P 500 index by more than 4.3% annually over this time period. That is less than 3% of the funds investigated.
Investors have a vast array of choices these days when it comes to low-cost index mutual funds and ETFs. There is no easier way to increase your returns over time than to move from higher-cost actively managed funds to lower-cost index funds and ETFs. And this doesn’t just apply to U.S. stocks. This also applies to U.S. bond funds as well as international stocks and emerging market stocks. Investors now have access to investing in international and emerging market ETFs that are tied to an index, which means very low trading activity. They also have much lower expenses than their actively managed counterparts.
So do yourself a favor and review your portfolio today. If any of your funds are actively managed and/or charge more than 0.3% per year in fees, take a look at index funds and ETFs that invest in similar themes. It’s an easy way to guarantee yourself more money when you retire.