Why Mutual Fund Expenses Matter – Lowell Sun
“If there’s anything in the world of mutual funds you can bring to the bank, it’s that expense ratios help you make a better decision. In every time period and data point tested, low-cost funds outperformed high-cost funds,” says Russell Kinnel, director of mutual fund research at Morningstar.
Since 2002, S&P Dow Jones Indices has published its S&P Indices Versus Active Dashboard (SPIVA), which compares the performance of actively managed mutual funds to their appropriate benchmarks. In 2021, the SPIVA report showed that 79.6% of all actively managed US equity funds underperformed their corresponding index. Over the past 10 and 20 years, 86.1% and 90.3% of actively managed US equity funds have underperformed their index.
Anyone who has read this column over the past 22 years knows that I am a big fan of index funds. Yes, I’m talking about boring, inexpensive, and interest-free index mutual funds. Index funds are low-cost mutual funds designed to track the performance of a particular index or asset class of stocks and bonds. All mutual funds have annual fees and expenses. These fees and expenses combine to form a fund expense ratio. The expense ratio tells you what percentage of your account is diverted to pay fund expenses each year. And since expenses are automatically diverted from your savings, you never really see what you’re missing out on.
One of the main reasons why index funds have outperformed the vast majority of actively managed funds is that they have much lower expenses. The average actively managed mutual fund has an annual expense ratio of approximately 1.2%. Index funds have an average annual expense ratio of 0.5%. Vanguard has index funds with an average expense ratio of just 0.1%. This means that on average an index fund can start each year with a 1.1% lead over actively managed funds. What difference can it make?
Portfolios A and B both start with $500,000 and earn the same 8% average return over 10 years. Portfolio A is invested in actively managed funds with an expense ratio of 1.2% and Portfolio B is invested in index funds with an expense ratio of 0.1%. The end value of portfolio A in 10 years (after expenses) is $973,856. Portfolio B: the end value (after expenses) in 10 years is $1,078,526. The additional savings of $104,670 that Fund B realized after 10 years was entirely the result of lowering its expenses. In other words, after expenses, the real average return of portfolio A is 6.8% and that of portfolio B is 7.9%.
If paying high expenses brought a higher return that investors could count on, it would make sense to pay them. However, every study I know of on mutual fund performance shows that paying above-average expenses makes above-average performance less likely. The reason is simple. Spending does not improve performance, it erodes it. Every dollar you pay or lose unnecessarily now costs you not only that dollar, but also the amount that dollar could earn over the life of your investment.
Martin Krikorian, is Chairman of Capital Wealth Management, a ‘fee-only’ registered investment adviser located at 9 Billerica Road, Chelmsford. He is the author of the investment books “10 Chapters to Have a Successful Investment Portfolio” and “7 Steps to Becoming a Better Investor”. Martin can be reached at 978-244-9254, Capital Wealth Management website; www.capitalwealthmngt.com, or by email at [email protected]