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.
12 Comments
J Carroll · June 29, 2011 at 6:36 am
Great post, thank you. Another direct expense many do not understand is loads. If you pay, for example, a 5% front-end load to buy a mutual fund through an adviser, that one-time 5% fee last forever. After, for example, 40 years of compounding, you have 5% less than you would have had with a no-load mutual fund that produced the identical results.
libertatemamo · June 29, 2011 at 9:58 am
Absolutely J. The scary thing is that it can be worse than what I represented in the post. Loads are yet another layer of potential fees many investors fail to really understand.
Paul
Cynthia · June 29, 2011 at 7:09 am
A log of FA charges 1.5% now. By using a FA, the investor will never win!
libertatemamo · June 29, 2011 at 10:00 am
Great point Cynthia. A financial adviser who is recommending active mutual funds for an investor plus charging an asset management fee, like 1.5%, is really doing some damage. And a lot of advisers even get commissions off the products they recommend.
Paul
jim goldstein · June 29, 2011 at 10:25 am
Informative post. Thanks. I have started going to Vanguard ETFs instead of mutual funds which charge 1 percent and higher. Great post thanks.
libertatemamo · June 29, 2011 at 10:53 am
Sure thing Jim. Vanguard is certainly the low cost leader. Don’t understand why more investors don’t use them. I discovered the other day that now for some of their really low cost admiral funds, like the SP500 index, the minimum investment is down to $10K from $100K. A great firm.
Paul
J Carroll · June 29, 2011 at 12:51 pm
Another plus for Vanguard. If you are a Vanguard Brokerage Services account holder and have at least $50K (I believe that’s the minimum, but check for yourself) in the account in Vanguard mutual funds or ETFs, their are no commissions for trading Vanguard ETFs; hard to beat.
libertatemamo · June 29, 2011 at 7:01 pm
Thanks J. Most brokers now have a pretty good list of commission free ETFs to choose from. Also, for Vanguard brokerage, if you meet the minimum, you get something like 10 free trades per year.
For individual stocks, Vanguard brokerage is an awful platform. TD and IB are far better. And as far as cheap goes, Wells Fargo brokerage gives you 100 free trades a year and no other fees. That’s the lowest cost deal I’ve come across.
Paul
J Carroll · June 30, 2011 at 7:18 am
Good conversation, here. Paul, or anyone else who would like to make an input, I assume from your statement that you have IB and other US based brokerage accounts. From past comments, you mentioned you trade (purchase, at least) your Fairfax shares via Pink Sheets; I assume that being done via a US based broker (not IB). Is that true? And, if yes, why would you not use your IB account and purchase/trade direct on the Toronto Exchange? Thank you.
Also, the whole area of fees and other expenses associated with investing directly on foreign exchanges is something I would be very interested in learning more about. I understand some countries have special stamp, and other, fees and taxes associated with using their exchanges. Also, currency exchange fees. Again, thanks.
libertatemamo · June 30, 2011 at 9:17 am
J, I have two brokers; TD and IB. Yes, I have bought Fairfax on the pink sheets. In general, its always cheaper to trade in the US markets so if I can I almost always buy shares on the US exchanges. For foreign stocks that means buying ADRs on the shares or on the pink sheets. My other two considerations are liquidity (avg daily volume) and bid/ask spreads. If there is not enough volume or the bid/ask spread is too high I’ll then look into the foreign exchanges. But sometimes it boils down to simpler issues like that’s where the money is. If the money is available in one account for a trade or investment I’m not going to transfer it just to get a little better price. After a certain level, the bid/ask spread is way more costly than the trading commissions. In the Fairfax case, the Canadian market happens to be about as cheap as the US market, at least through IB, so all else being equal, I’d rather do the trade/investment on the US exchange in US dollars. I owned/traded shares on the Hong Kong exchange and the London exchange with no issues.
As far as investing on the foreign exchanges, you can find out about all the fees from the broker’s site. IB makes it the easiest and cheapest of any US broker I know. Its all on-line and all the fees are clearly documented. See this IB link for foreign trading costs. As I said, the US is usually the lowest cost market in the world to trade so of the shares are listed in the US, ADR or pink sheets, your usually better off trading it on the US exchange.
Hope that helps.
Paul
VallAndMo · August 25, 2011 at 3:00 pm
Hello Folks,
We are a brazilian couple preparing to move to the US in the medium term (if you want to know more about our plans, please check; In preparation for that, we are considering moving part of our assets to the US right away and investing it in a mix of no-load, low-fee, good yield mutual funds (something like 50% VIPSX and 50% VTSMX) as a hedge in case the dollar starts climbing back up the ladder in regards to the brazilian real.
We have contacted a few banks here in Brazil who have operations in the USA and so would enable us to open an investment account there, but not one of them will enable us to invest in Vanguard funds :-/. They offer us funds from the following companies:
Alliance Bernstein
Eaton Vance
Fidelity
Franklin Templeton
Invesco
Janus
MFS
Permal Offshore
Putnam
Does any of you have any tips regarding what companies and funds are best, what to avoid, etc, or any other info for a foreign looking to invest in the USA? It seems that the funds offered doesn’t even have 5-letter codes (so we can’t check them up on MorningStar, for example), only ISIN codes.
Thanks in advance,
—
Vall & Mo.
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Investing on the cheap with ETFs « Investing For A Living · July 15, 2011 at 1:48 pm
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