This post is as much directed to the blogging community as it is to my wife’s employer. You see, her employer offers a 401k plan (a good start) and a 4% dollar-for-dollar match (great!). However, her 401k plan is run through American Funds (bad). If you are not familiar with American Funds, they are known for their high investment fees. Let’s take a look at why fees matter.
Know Your Fees
It is impossible to invest in a mutual fund for free. There are three basic types of fees to watch for:
- Expense Ratio: This reflects the recurring management fees as a percentage of the funds assets. For example, if the expense ratio is 1% and you own $100,000 worth of a fund, you will pay $1000 per year.
- Sales Fee (otherwise known as a Load): This represents a fee that is paid immediately when purchasing shares of the mutual fund. For example, if the sales fee is 5% and you try to purchase $100,000 worth of a fund, 5% of that amount, or $5000 will be deducted immediately, so you will only be purchasing $95,000 worth of the fund.
- 12b-1 Fee: This is a fee used for distribution and marketing expenses. This also expressed as a percentage of assets and may be included in the net expense ratio.
Do Fees Matter?
It is easy to see the immediate effect of a sales load, but the effect of the expense ratio might be more insidious. Let’s compare two different funds that a beginning investor might have in their 401k, the Vanguard Target Retirement 2045 fund and the American Funds Target Retirement 2045 fund.
None of Vanguard’s funds have any sales loads or 12b-1 fees. They DO have expense ratios, but these tend to be quite low. The expense ratio of the Vanguard Target Retirement 2045 fund is 0.16%.
In comparison, many of American Funds’ offerings have sales loads, high expense ratios, and 12b-1 fees. The American Funds Target Retirement 2045 fund does NOT have a sales load, but it does have 12b-1 fees.
The American Funds Target Retirement 2045 fund’s expense ratio is over a percentage point higher than Vanguard’s Target Retirement fund (1.53% – 0.16% = 1.37%). That might not seem like a lot. You’re only losing a penny on the dollar each year, right? Wrong.
A reasonable expected inflation-adjusted return from a Target Retirement 2045 fund would be around 5% per year. If 1.37% per year is eaten up by fees, then you are only receiving 5%-1.37% = 3.63% return per year. Therefore, you are losing out on 1.37 / 5.0 = 27% of your investment returns per year.
Let’s compare what happens when $100,000 is invested in each of these funds and allowed to grow over 30 years. The inflation adjusted return on each fund is assumed to be 5%, so accounting for expenses, the Vanguard fund grows at 4.84% per year and the American Funds Target fund grows at 3.47% per year.
At the end of 30 years, the Vanguard account’s value is $412,000 and the American Funds’ account value is $278,000, a difference of $134,000. That’s hardly pennies!
Why the Higher Fees?
At this point, you’re probably wondering why American Funds charges so much higher fees than Vanguard? Well, their argument is that they are ACTIVELY managing the fund in hopes of obtaining higher returns than the overall market. In comparison, Vanguard focuses on PASSIVE investing that simply seeks to match the overall return of the market. Let’s see how well that worked with the Target Retirement 2045 funds.
You can see from these images that the 10-year return of the Vanguard Target Retirement 2045 Fund was 5.73% and that of American Funds was 5.66%, essentially identical. So much for higher returns with active investing.
Most Active Managers Are Unable to Beat the Market
Lest you think that I am singling out these specific Target Retirement Funds, studies (such as those from Morningstar and S&P Dow Jones Indices) show that most active managers are unable to beat the market, and the ones that do for short periods of time are unable to do so consistently over many years.
In the Morningstar study, approximately 80% of large cap actively managed funds underperformed the market over a 10 year period.
Moreover, the returns on the actively managed funds generally trailed the returns on passively managed funds.
In the S&P Dow Jones Indices Study, no individual fund managers were able to beat the market over a 3 year consecutive period from 2013 to 2016.
Stop Throwing Away Your Freedom
Hopefully at this point it is clear to you that higher fees generally result in poorer overall returns. Do yourself a favor and invest in passively managed low fee index funds, such as those at Vanguard or Fidelity. The difference could be several hundreds of thousands of dollars over your investing career. Now please excuse me while I go present this to my wife’s HR department.
I can see why so many people prefer the Vanguard funds–who wants to pay fees hand over fist? It sucks because there will probably never be an entirely fee-free investment option, but that’s just how it goes.
Investing will never be completely free, but the 0.05% expense ratio for the Admiral Shares version of the Vanguard Total Stock Market Index fund is pretty close!
There is no doubt that in the world of mutual funds in which the so-called “experts” cannot beat the index that it makes no sense to pay extra fees.
Exactly. You can’t control your returns, but you can control your fees. Make sure they’re as low as possible!
Well written, LFMD. Warren Buffett estimated in his most recent annual letter that investors have wasted $100 billion in fees to fund managers over the past decade — and that’s a conservative estimate!
Some people (including Dave Ramsey) believe that you can beat the market, AND beat it enough to offset those fees. I’m obviously quite skeptical, but there will always be those who are willing to pay for that chance, even if it never materializes.