Why Mutual Fund Fees Are Important But Often Ignored + More Vanguard Fee Savings

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.

Comments

  1. Great post and glad to hear that competition from other ETF securities is driving fees down even further. The under performance of mutual funds has been well exposed for years and yet they maintain their popularity and prominence. There are more mutual funds than there are U.S. equities and the only ones who win there are the mutual fund managers. Vanguard is smart to recognize the shift to low cost ETFs and I that will benefit them and us in the long run. What is the advantage of Admiral shares over Investor shares by the way?

  2. Kurt @ Money Counselor says:

    Agree 100%–mutual fund fees have a devastating effect on a nest egg. Thank goodness for Vanguard and John Bogle, one of the few truth-tellers in the investing world I think.

  3. Thanks for the post. This is such an important point. See also my guest post at Bargaineering about this: http://www.bargaineering.com/a.....ratio.html
    It’s definitely something more folks should be aware of when putting together a well-balanced portfolio.

  4. Jenna, Adaptu Community Manager says:

    Thanks for the Vanguard update.

  5. Matthew C. Waterman says:

    Facebook is about to make stock trading free. Let’s hope they do better at it than Zecco did.

    http://www.examiner.com/articl.....roker-fees

  6. I’ve written about Loyal3 before, it’s interesting but not a game-changer in my opinion.

    http://www.mymoneyblog.com/loy.....tocks.html

  7. I agree 100%. Without a bill for your fees, most people are oblivious to fees and what they do to your return over time. Kudos to Vanguard and you for trying to inform investors!

  8. I like how you’ve put the impact of the fee into perspective: “paying 1% to a manager is like paying 1/3rd of all your earnings.”

    In addition to the fee taking a significant chunk of your profits, it’s not very often that a high fee can be justified by superior returns. Some investors mistakenly believe in the theory that investing in an actively managed fund will be worth the greater returns. However, a high fee fund is not guaranteed to produce higher returns.

    We just did an infographic about this that shows the 5 funds that charge the highest fees while providing the lowest returns, even underperforming the benchmark, and their $812,875,410 annual cost to investors. http://www.jemstep.com/blog/20.....f-success/

  9. anonymous says:

    I have investments in the Vanguard Target Retirement 2040 fund that has an expense ratio of 0.19%. This Fund is made of of several other Vanguard Funds (like Vanguard Total Stock Mkt Index, Vanguard Total International Index, etc.), which have expense ratios of +/- 0.22%. I’ve read through the propsectus, but can not tell if I am being charged only 0.19% or 0.19% PLUS 0.22%. Does anyone know how the fees work in TOTAL for the Vanguard Target Retirement Funds?

  10. @anonymous – Vanguard Target Retirement funds simply charge the fees of the underlying funds. There are no additional layer of fees for the Target fund itself. Some other Target data funds from other companies do charge another layer of fees, however.

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