Paying More in Fees Can Get You Less in Returns

I recently reviewed the portfolio of a young man who had inherited almost $1 million. He had entrusted his funds to a large mutual fund company. He thought his portfolio was "well diversified" because almost all of it was invested in an S&P 500 Index Fund. Several issues were apparent, which you might be able to relate to your investments.

He was paying a 1% "management fee" to the fund family for providing him with investment advice. His advisor purchased an S&P 500 index fund with an expense ratio of 1.50%. Added together, he was paying 2.50% of his assets to invest in an index fund that could be purchased from Vanguard for 0.17% (Vanguard 500 Index Fund Investor Shares [VFINX]). By doing so, he would reduce his fees from 2.50% to 0.17% since he would eliminate the management fee as well.

The expense ratios of S&P 500 index funds range from very low to extremely high. For an egregious example of an indefensibly high expense ratio, consider the State Farm S&P 500 Index B (SNPBX). It has an expense ratio of 1.49%, and a deferred load of 5.00%. This fund has assets of $547 million.

A small difference in expense ratios can have a dramatic effect on returns. Let's assume an S&P 500 index fund and Vanguard's both return 8% annually, before costs and you invest $10,000. A savings of only 1% annually on expenses would mean the lower cost fund would yield an additional $63,000 over forty years ($201,000 versus $138,000). That's a big difference.

There are other problems with the underlying assumption that buying an S&P 500 index fund is sufficient diversification. It omits bonds, which should be included in most portfolios. It also omits exposure to international markets and to thousands of mid-cap and small-cap stocks. If you are interested in putting together a globally diversified portfolio of low management fee index funds, you could consider Vanguard's Total Stock Market Index Fund (VTSMX) for exposure to the domestic stock market; Vanguard's Total International Stock Index Fund (VGTSX) for exposure to the international stock market and Vanguard's Total Bond Index Fund (VBMFX) for the bond portion of your portfolio.

While index funds are typically lower cost than comparable actively managed funds (where the fund manager attempts to beat a designated benchmark, frequently without success), there can be a big difference between index funds tracking the same index. Check the expense ratio carefully before you make a final decision.

Dan Solin is a Senior Vice-President of Index Funds Advisors (ifa.com). He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

 

 

 

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Comments

[olddognewtrick]

02:00 PM on 11/24/2011

What's the old saw about the easiest way to end up with a million bucks in the stock market? Start out with two million bucks...

[48thGuy]

07:33 PM on 11/23/2011

Maintaining a 0% expense ratio in a portfolio is as critical as what is being held in a portfolio. I buy and hold stocks and bonds directly. DRIP the dividends and reinvest the income from the bonds. No management fees or fund expense ratios for me, I don't like partners when it comes to my money.

[robinhood1]

11:11 AM on 11/23/2011

Many Americans are very ignorant when it comes to their finances. Most of my former colleagues had no idea what they were paying in 401K fees and that some of the funds offered much lower fees than others. Notice that this article has not attracted many comments from the 99%. I guess they would rather complain about the top 1% instead.

[pinetrale]

11:07 PM on 11/22/2011

You should only pay a higher management fee for alpha, not beta Alpha is what a good manager can offer against the rest of the pack. Beta is simply the index, so you just want a good liquid reliable manager with adequate back office support. Why someone in good concience would sell him such an expensive beta product is just outright wrong. Taking peoples money like this should be treated like fraud. Also I wouldn't say simply owning an S&P index fund is good diversification at all. First read up on diversification on the net or in books, learn the material, then consult with several experts on a service basis and see if it all jives. Comparison shop funds and fund shops and see if the managers are stable and read up on them. Then consider splitting your investments among several different shops should one of them run into trouble one day and freeze up your funds. And remember the tax problem of selling shares, any shares and the limitations on how often you can sell which is currently four times a year. Find out just how do you sell shares and how often and the tax implications "should" your investment grow. They may not, or worse lose principle, decade after decade. Go ask people who bought at the peak of the tech boom in 2000 how much underwater they are today. Those who kept even are lucky. sad but true.

[Sweet Liberty]

07:27 PM on 11/22/2011

Why is it that we American consumers have no problem paying fees but throw a fit when it comes to paying taxes? I for one, absolutely despise fees. No matter what kind and to whom. Bank fees are the worst.