Investment fees are such a detriment to future wealth that literally investors should flee from them like their lives depended on it. I’ve touched on the topic of investment fees before using hypothetical fees and looked at their long term impact. It’s awful. But it looks even worse when fees are compared across different investment vehicles. That’s the subject of this post. I’ll compare the fees of active mutual funds to index funds and to individual stocks and look at their impact over different time periods. The results are sobering.
I was recently re-reading the great book, The Investor’s Manifesto , by William J Bernstein. Like the majority of William J Bernstein’s (not to be confused with the late great Peter Bernstein) books he advocates a passive investment approach with a focus on index funds and proper asset allocation. One of his main arguments focuses on fees. One of the main reasons that the majority of active mutual funds fail to beat the market averages is due to fees. Fees put the average active mutual fund in the hole from day one. Index funds, on the other hand, start out the race with a nice tailwind. Below is a table from The Investor’s Manifesto that compares the average fees of different types of active mutual funds. I’ve added SP500 index fund data, both of the average SP500 index fund and that of the low cost champion, the Vanguard SP500 index fund. The table assumes investment in a tax deferred account.
The first thing to note is that expense ratios are not the only fees that investor’s pay in the end. There are other fees, like the commissions the fund pays to their broker, the bid/ask spreads of the stocks, and impact costs. Impact costs are the price effect that large mutual fund buying and selling can have on a given stock. Impact costs and bid/ask spreads are known as transactional costs and are seldom reported by mutual funds. The next thing to note is the shear magnitude of the differences. Comparing apples to apples, the avg large cap mutual fund to the Vanguard SP500 index fund, yields a difference of 2.08% per year in fees! That’s a huge headwind to overcome when you’re trying to beat the market. And its even worse when looked at over a period of years. But before I do that lets add in investing in individual stocks to the comparison.
It may come as a surprise to some but investing in individual stocks can be the lowest cost option for any investor. The basic reason is that fees for investing in individual stocks are only paid twice, once on entry into the position, and once on exiting the position. The fees do not compound. Lets add individual stocks to the previous table. I’ll assume a $50,000 portfolio, a $5 on-line trading fee for buying or selling a position, and a bid/ask spread of 0.3% similar to the large cap mutual fund. Here is the updated table.
Only the Vanguard index fund beats the individual stock position. Now, lets look at the effect of different holding periods. Since investment fees for funds are paid annually the effect of fees compounds over time. In the table below I show the total effect of fees over holding periods of 1 to 10 years.
The impact of fees over time is truly staggering. Over a ten year period the avg large cap fund will cost you almost a quarter of your assets versus the lowest cost index fund which will cost you just over 1% of your assets! And even better an individual stock holding will cost you just 5% of what the lowest cost mutual fund in the world will cost you! If these numbers don’t make you fee for your life I don’t know what will.