Why mutual fund expenses matter
“If there’s anything in the whole world of mutual funds that you can take to the bank it’s that expense ratios help you make a better decision. In every single time period and data point tested, lowcost funds beat high- cost funds,” says Russell Kinnel, Morningstar’s director of mutual fund research.
Since 2002, S& P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) scorecard, which compares the performance of actively managed mutual funds to their appropriate index benchmarks. In 2021 the SPIVA report showed that 79.6% of all actively managed U.S. stock funds underperformed their corresponding index. Over the last 10 and 20 years, 86.1% and 90.3% of actively managed U. S. stock funds underperformed their index.
Anyone who has read this column over the last 22 years knows I am big proponent of index funds. Yes, I am talking about boring, inexpensive and unexciting index mutual funds. Index funds are low-cost mutual funds that are designed to track the performance of a particular index or asset category of stocks and bonds. All mutual funds have annual fees and expenses. These fees and expenses combine to make up a funds expense ratio. The expense ratio tells you what percentage of your account is being siphoned out to pay for the fund’s expenses each year. And since expenses are automatically siphoned from your savings, you never really see what you’re missing.
One the biggest 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 about 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 begin each year with a 1.1% head start on actively-managed funds. How much of a difference can that make?
Portfolio A and B both start with $500,000 and earn the same average return of 8% over 10 years. Portfolio A is invested actively managed funds with an expense ratio of 1.2% and Portfolio B is invested index funds with an expense ratio of 0.1%. Portfolio A’s ending value in 10 years (after expenses) is $973,856. Portfolio B’s: ending value (after expenses) in 10 years is $1,078,526. The additional $104,670 in savings that Fund B earned after 10 years was entirely the result of its lower expenses. Put another way, after expenses, Portfolio A’s actual average return is 6.8% and Portfolio B’s is 7.9%.
If paying high expenses brought a premium return that investors could count on, then it would make sense to pay them. However, every study that I am familiar with on mutual-fund performance shows that paying above-average expenses makes above-average performance less likely. The reason is simple. Expenses don’t enhance performance, they erode it. Every $1 you unnecessarily pay or lose now costs you not only that $1, but also the amount that $1 could earn compounding over your investment lifetime.
Martin Krikorian, is president of Capital Wealth Management, a “Fee- Only” registered investment adviser at 9 Billerica Road, Chelmsford. He is the author of the books, “10 Chapters to Having a Successful Investment Portfolio” and the “7 Steps to Becoming a Better Investor.” Martin can be reached at 978-244-9254, Capital Wealth Managements website; www.capitalwealthmngt.com, or via email at, info@ capitalwealthmngt.com.