The importance of keeping investment expenses to a minimum
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When investing, the majority of people don’t evaluate the significant impact of investment expenses over time. There are three classes of mutual funds relative to expenses; index funds, no-load managed mutual funds, and loaded mutual funds.
Index funds are designed to mirror major market indices such as the Wilshire 5000 (the largest 5000 US Corporations) or the S&P 500 (the largest 500 US corporations). The most common index that you hear quoted daily is the Dow Jones Industrial (which tracks 30 large Corporations).
One key feature of an index funds is that the ownership of different shares is proportion to the market value of each corporation. This is to say that the Wilshire 5000 index invests a lot more in large corporations such as Exxon and Microsoft, and a lot less in a small growing company such as Starbucks. Index funds are self-correcting in that they will increase investments in winning companies like Microsoft and Starbucks and divest from tanking companies such as and Enron and WorldCom. Given that these adjustments occur daily, an index fund investor can sleep soundly knowing that they don’t have to worry about the performance of individual stocks.
The most significant advantage of index fund investing is the low expense ratio fee. The average managed mutual fund has an annual expense ratio of 1.35%, while index fund expense ratios from low cost mutual fund companies such as Vanguard and Fidelity are 0.2%. This represents a 6X reduction in cost from the typical mutual fund- this is like buying a $30,000 car for just $5,000.
Managed mutual funds differ from index funds in that the fund manager attempts to beat the index by picking a portfolio of stocks. In the long-term, less than 20% of managed funds outperform index funds; therefore the risk with managed funds is that 80% of the time you will end up with lower performance plus higher expenses. Average expense on a no-load managed fund is 1.35%, but can range from 0.4 to 2% depending on the specific fund. I recommend that you only purchase managed funds that have outperformed their comparative index for last 3, 5, and 10 years.
Loaded mutual funds charge an upfront sales fee of 3% to 6% and have annual expenses that range from 1 to 2%. The upfront sales fee is charged to provide a commission to the salesperson. For example, a 5% load fee means that only $95 out of every $100 is invested. I recommend that you NEVER invest in loaded mutual funds since a portion of your money is confiscated.
The following graph shows the impact of expenses when investing $100 per month over 30 years. In this calculation different levels of fees are applied to average annual historic stock market returns. In reality the returns for different mutual funds vary and 80% of managed funds do not achieve average market performance. The black dashed line represents a portfolio without fees.
The impact of expected returns based on the expense ratios and upfront fees is quite dramatic. Examine the difference in the expected return at 30 years of each portfolio versus the benchmark index. The expenses of an index fund only absorb 4% of the portfolio potential, while the expenses of a loaded fund confiscates 35% of your portfolio potential. A mutual fund with a 1% expense ratio eats into 17% of your portfolio. Many investors do not notice the impact of fees until their portfolios are large. I recommend that you think with the end portfolio in mind. Employ low fee mutual funds all of the time to maximize your nest egg.
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