With all of the market upheaval in the last three years, it’s time for investors to ask the question: Am I getting what I am paying for from my investments?
If you are invested in mutual funds, which most investors should be in order to diversify, you may be aware of the fund’s expense ratios. But that is only part of the picture. This expense ratio does not account for trading costs, which can add up quickly in most actively managed funds. In addition, if a fund keeps excessive amounts of money in cash, that can drag down returns over time. And finally, taxes will end up being the biggest expense most investor’s pay. When you total up all of these costs, that fund with a 1.25% expense ratio may end up really costing 4%-5% annually.
The reason most investors pay this type of cost is because
they feel that the fund manager, through solid stock picking, will be able to
outperform their benchmarks and peers by more than these costs. Unfortunately, the statistics do not prove
this to be true. Over the last 10 years,
less than 25% of large stock funds have outperformed the S&P 500; their
most common benchmark. (Source:
Morningstar, Inc. data through
The solution to these problems are index funds. When most people hear the term index fund, they think of funds that track the S&P 500. But there are index funds that represent many different asset classes and market sectors, and their advantages are numerous. First, they are much less expensive than actively managed funds, primarily because there is no need for the expensive management and research staffs. Whereas an active fund may have an expense ratio over 1%, Vanguard’s Total Market Index Fund has an expense ratio of 0.20%, and DFA’s Large Company Fund has an expense ratio of 0.15%. These funds only buy and sell when the index they follow changes, thus portfolio turnover is dramatically less. This results in much lower trading costs, as well as lower taxable distributions to shareholders.
Another important advantage to index funds is that you know exactly what you are getting when you invest in one. The problem with active funds is that they don’t always invest in the way they advertise. A fund may state that it invests in large growth stocks, but over time may start to invest in small company stocks. This is referred to as style drift. Style drift really throws a monkey wrench in efforts to build a diversified portfolio. For example, if you build a portfolio with the intention to have 15% of your assets in small stocks, but your large growth fund also has 30% of its assets in small stocks, you are unknowingly over weighted in that area. With an index fund, that problem is eliminated.
In today’s tumultuous market, uncertainty abounds. Investors need to watch expenses, select an asset mix that is appropriate for their level of risk, and stick with the plan.