Get more, pay less. This promise has people jumping in most areas of life. A bottle of Domaine Leroy Musigny Grand Cru for the price of two-buck Chuck. A penthouse suite instead of a motel room. A free flight upgrade to first class. All of these decisions are no-brainers, so why does the same principle not hold for investment habits?
The average mutual fund charges 1.3% in fees. This cost goes towards paying the hefty salaries of fund managers, administrative expenses, brokerage commissions, and even advertising. Theoretically, one might think active management leads to higher returns. That is not the case. A growing body of evidence shows that higher expense funds do not, on average, perform better than lower expense funds. In fact, the average actively managed fund loses to a low-cost index fund, free of all fees and expenses. "Independent studies conclude that a portfolio composed of five actively managed funds has only about a 30 percent probability of beating an all index fund portfolio over 1 year, about 15 percent probability over 5 years, 8 percent probability over 10 years, and just 2 percent over 25 year." wrote Rick Ferri in his book The Power of Passive Investing.
Fund fees and performance are inversely, and clearly, linked. When
Investors in a low-fee fund not only earn higher returns, but also save more money. The lower your costs, the greater your share of an investment’s return. Vanguard looked at the impact of expenses of a portfolio with a starting value of $100,000 over the course of 30 years, that grows an average of 6% annually. “In the low-cost scenario, the investor pays 0.25% of assets every year, whereas in the high-cost scenario, the investor pays 0.90%,” the research said. “The potential impact on the portfolio balances over three decades is striking—a difference of almost $100,000 between the low-cost and high-cost scenarios.”
The evidence is overwhelming that lower fee funds perform better, and generate higher returns for their investors. Passive ETFs such a the Vanguard S&P 500 ETF (VOO) can cost as little as .05%, as opposed to the 1.3%, which means that the average active fund costs 25 times more. High fees eat into your savings, and this, in turn, impacts your quality of life and future.
In an article titled “The Arithmetic of Investment Expenses,” Nobel Prize winning Stanford professor William F. Sharpe estimated that a person saving for retirement who chooses low-cost investments could save 30% more money, and have a standard of living throughout retirement more than 20% higher, than that of a comparable investor in high-cost investments
High fee funds mean you are paying more, to get less in return. This, as any rational consumer or investor can tell you, makes no sense. Even Warren Buffett, the most famous investor in the world, advocates investing in low cost S&P funds. Quality and cost may be linked when it comes to wine or hotels; however when it comes to choosing an investment fund, you don’t get more for paying more. In this case, the less you pay, the more you save. Those thousands upon thousands of dollars will serve you far better in a retirement account than frittered away on fees.
The views expressed represent the opinion of the author and are not intended to reflect those of FutureAdvisor or serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities. Past performance is not indicative of future results.
