I am often reminded when talking with friends and coworkers that most people don’t understand the important of low fees when it comes to investing. The Vanguard blog had a recent post exploring why a 1% expense ratio is much more significant than it appears. The problem is that expense ratios aren’t charged to you directly as a line item like an overdraft fee or a monthly bill – it is quietly taken away in tiny pieces from your returns which makes it easy to ignore.
For another, fees are expressed as a fraction of assets. A 1% equity management fee seems small and reasonable. “One percent” just sounds tiny – as in “there’s a 1% chance of rain tomorrow.” But suppose you reframe fees in other terms. Suppose you expect a stock fund to earn 8% over the long run. Assuming inflation of 3% and a tax rate of 25%, you’re in effect paying one out of every three dollars of future expected return in costs.* A fee of “one third of all of the money you make” sounds like a lot, especially when many money managers could do worse than the market averages.
Basically, if you are expecting to earn 3% a year above inflation after taxes, paying 1% to a manager is like paying 1/3rd of all your earnings. As you can see below, I could own the S&P 500 for as little as 0.05%. Things get even worse when looking at bond funds and their tiny yields.
Research has shown repeatedly that costs matter more than star ratings and past performance. The lower the expenses, the less headwind year in and year out.
With that knowledge, Vanguard has announced another round of fee cuts! Vanguard says the price drops are a result of them being client-owned and passing on any savings resulting from increased assets. Others speculate that it’s a reaction to competition from other low-cost ETF providers like Schwab. Either way, investors win. The drops are pretty small, but to me it’s like getting a little guaranteed boost in returns that will compound every year. A selected sample of funds with fee drops below:
|Funds In My Personal Portfolio||Old expense ratio||New expense ratio|
|Vanguard 500 Index Fund (Admiral/ETF Shares)||0.06%||0.05%|
|Vanguard Total Stock Market (Admiral/ETF)||0.07%||0.06%|
|Vanguard Small-Cap Value Index Fund (ETF)||0.23%||0.21%|
|Vanguard Small-Cap Value Index Fund (Investor)||0.37%||0.35%|
|Vanguard Total Bond Market Index Fund (Admiral/ETF)||0.11%||0.10%|
|Vanguard Inflation-Protected Securities Fund (Investor)||0.22%||0.20%|
Admiral shares are now open in most index funds with a $10,000 investment, and you can always start like I did with the Investor shares at $3,000 and convert to Admiral when the balances grow. ETFs usually offer the same low expense ratios as Admiral shares, but you should also keep in mind the cost of trade commissions. Buying Vanguard ETFs and mutual funds directly with an account with Vanguard is free. TD Ameritrade also offers commission-free trades on a wide variety of Vanguard ETFs (along with other providers).
Over the last year or so, Vanguard has made several moves that lowered my portfolio costs. They added Admiral shares, removed purchase fees on their Emerging Markets fund, and dropped expense ratios again.
By Jonathan Ping | Investing | 4/30/12, 2:33am