Thursday, July 22, 2010

Costs Matter

A seemingly small difference in mutual fund costs can make a huge difference in how your investment grows over many years. A 1% or 1.5% expense ratio may not sound like a lot, but compared to the 0.2% or less you will pay for a low-cost index fund, your investment returns are most likely to be severely diminished by the higher costs over an investing lifetime of 50 years or more.

The chart below shows the growth of $10,000 at two different rates: 8% and 5.5%.1 The lower rate represents the impact of an additional 2.5% in costs for a high-cost mutual fund relative to a low-cost mutual fund. Note that after 30 years the value of the high-cost fund is only 50% of the value of the low-cost fund, and after 50 years it’s about 31% ($145,420 vs. $469,000).


Regardless of the absolute rates, the percentage difference in returns is about the same for a 2.5% difference in fund costs. For example, at 6%, $10,000 would grow to $57,435 in 30 years, while at 3.5% it would grow to only $28,068—about half as much.

The cost impact is significant even with a cost difference of only 1%. A fund that returns 4% per year compared to a lower cost fund that returns 5% per year will result in a shortfall of 25% after 30 years ($32,435 vs. $43,220 on a $10,000 initial investment) and about 42% after 50 years ($71,070 vs. $114,675).

The higher costs of an expensive, actively-managed mutual fund come not only from the higher management and administration expenses (expressed as the expense ratio), but also from the the costs of high portfolio turnover (buying and selling stocks)—not included in the expense ratio, and worst case, from a sales charge.

A sales person will try to convince you that the higher costs of an actively managed fund are justified, proposing that the fund manager’s expertise will result in higher investment returns. However, many studies have shown that this is not the case. Over long time periods, the average actively managed mutual fund underperforms the market by about the amount of its expenses. From 1980 to 2005, the average stock mutual fund underperformed the S&P 500--a widely used measure of the US stock market—by about 2.5% per year.

If you think about it, this is not surprising. Since “the market” consists of all investors, and active managers are a big percentage of all investors, it’s common sense that the average return for all active managers will be the market return less the average costs of active management. By contrast, by investing in a low-cost, total stock market index fund, you are certain to receive approximately the market return less the much lower costs.

So, why not stack the deck in your favor, and invest in low-cost index mutual funds instead of high-cost actively-managed mutual funds?

Perhaps you’ve noticed, or your broker has pointed out, that a particular high-cost fund has outperformed the market over the last 5 or 10 years. Sorry, but the evidence clearly shows that actively managed funds with superior performance over the previous 5 or 10 years are more likely than not to underperform during the subsequent 5 or 10 years.2 You can always find an expensive mutual fund that has done well over the last few years, and it’s in any sales person’s interest to sell you something that will make them money, not something that will save you money.

The only justifiable reason I know of to buy a high-cost mutual fund is that your 401(k) or 403(b) plan doesn’t offer any low-cost index funds, in which case I would look for the lowest-cost funds that most closely track their benchmark indices. Other than that, I would invest primarily in low-cost index funds; you can’t control the market, but you can control your costs.


1. This post is based largely on information contained in Chapter Four of John Bogle’s outstanding book, The Little Book of Common Sense Investing.

2. An example of a study that shows lack of persistence of mutual fund outperformance is summarized on page 15 of The Only Guide to a Winning Investment Strategy You’ll Ever Need by Larry Swedroe. From 1976 through 2002, the top 30 funds in each 5 year period underperformed the S&P 500 through 2002 by an average of 3% per year.

If you’re reading this online, you can follow this link to an article that has a pretty good, concise discussion of actively-managed funds vs. index funds. The article cites several studies that show the low probability of actively-managed funds outperforming index funds.

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