The Long-Term Cost of Investing in the Wrong Index Fund
If you’ve invested in a simple three-fund portfolio or a variation with a quality, low-cost firm, you’ve probably got costs of well under a tenth of a percent. Would you believe there are companies chargin more than 1% per year for an S&P 500 fund?
It’s true, and you can find them from big names like Wells Fargo (WFINX), BlackRock (BSPZX), and J.P. Morgan Chase (OEICX). Even worse is the Rydex S&P 500 fund (RYSYX) with an expense ratio of 2.33%.
Those costs are absurd, and they can do serious damage to your portfolio. I’ve said it before, and our friend at Just Start Investing is about to say it again in today’s guest post. If you’re not careful, Investing Fees Will Cost You Millions.
About the Author: Just Start Investing is a personal finance website that makes investing easy. Learn the simple strategies to start investing today, as well as ways to optimize your credit cards, banking and budget.
The Long-Term Cost of Investing in the Wrong Index Fund
Your index fund might be costing you millions of dollars.
That’s right, it’s literally costing you. Index investing is a great strategy, but not all index funds are created equal. Some charge significantly more than others for their services.
If deciding to invest in index funds is a great first step, minimizing your index fund fees is the necessary second step.
Quick, What’s an Index Fund?
Index funds have been around awhile, and most of you by now are likely familiar with them. Though, with the rise of ETFs and with indexes before more niche, it’s worth a quick refresher on what an index fund is and its intended purpose.
An index fund is a mutual fund that is designed to mirror an established index (like the S&P 500). It’s the opposite of an actively managed mutual fund that hires a fund manager to pick stocks to invest in.
The index fund was originally created by John Bogle for every day investors to be able to mirror the overall stock market. That is still the best use for index funds today.
It’s easy to get distracted by flashy ETFs and mutual funds that mirror niche markets or offer free trades. But the best strategy is to stay disciplined and stay investing in broad index funds for the long term.
The Millionaire Dollar Mistake When Picking an Index Fund
So, with that said, the most important factor to look at when picking an index fund is its expense ratio.
Simple stated, an expense ratio is the percentage of your investment that is used to pay the fund every year. It’s your cost.
This expense is often overlooked, but it shouldn’t be. It can cost you millions of dollars over the long term.
Why Expense Ratios Can Cost So Much
Expense ratios vary from 0% (thanks to new Fidelity funds) all the way to 1% or higher. For many actively managed funds, it can even be 2% or more.
Thankfully, most established index funds and ETFs offer fees more in the range of 0.02%-0.15% (thanks to Charles Schwab and Vanguard).
Sure, it’s clear that the difference between a 0.02% fund and 1.00% fund can be huge (all else equal). Actually, for an investor with a large nest egg of $1,000,000, it can cost you over $4,000,000 over a 40 year span!
For most, that’s easy to understand. It’s essentially a full percentage point difference in return, which is going to compound to some big differences over time.
What’s less known, is that the difference between the 0.02% fund and 0.15% fund can still be huge!
In the same scenario, an investor who starts with $1,000,000 and invests over 40 years in the 0.15% fund will have $643,449 in higher costs than the 0.02% fund.
Now let’s say that investor is constantly saving and invests an additional $25,000 every year on top of the $1,000,000 they started with. Now the cost difference between the two funds is $790,645!
Over a quarter of a million dollars.
But what if you earn slightly less and are starting with a smaller nest egg? Do these costs still apply?
Yes, just with proportionally smaller numbers.
Someone with $100,000 now who is investing $10,000 a year will have $123,223 in added costs (0.15% compared to a 0.02% fund).
Yes, the lines on the chart appear close together, but $100,000 is a lot of money no matter who you are. Don’t let it slip away!
A Couple Of Caveats
There are a couple of assumptions I want to make clear on the above examples.
For one, this is assuming that all funds are created equal. Obviously, in reality, they are not.
Most index funds matching the Dow Jones or S&P 500 can be assumed to have similar returns, so when comparing funds within that category the expense ratio is a huge factor to consider.
Though, if you are considering international funds or small cap funds that have a slightly higher expense ratio, you need to take into account if that expense ratio is worth the diversification or higher expected returns from these funds.
If your small cap fund has a 0.50% expense ratio and only beats the S&P 500 by 0.25%, it likely was not worth the purchase. You could have gotten an S&P 500 fund for 0.05% (or less) and netted out 0.20% ahead.
That 0.20% can add up quick year after year.
To help give you a quick view of how much an expense ratio is really costing you, I created the table below. It lays out what 0.01% can cost every year depending on how large your investment is.
You can quickly see based on your nest egg how much just a 0.01% increase in expense ratio can cost you over time.
Note: this assumes 7% annual growth of your investment.
Other Things to Consider when Buying Index Funds
The expense ratio is arguably the most important thing to examine when buying an index fund. Though, there are a couple other things to keep an eye on as well.
Other fees have the ability to cost you a ton of money, just like an expense ratio. Some common ones to minimize are:
- Load Fees: Load fees are sales commissions that are sometimes charged to you when you buy or sell a fund.
- Transaction Costs: Transaction costs is what a broker charges you to make a trade. Vanguard and Charles Schwab charge $0 when trading their own funds.
- Spreads: Spreads apply to ETFs, which trade like stocks. There is a bid and asking price with the middle man taking the difference.
- 12b-1 Fees: This is a fee sometimes charged to cover administrative costs. Sounds like an expense ratio dressed up in a different name to me.
Dividend Yield and Past Capital Gains Distributions:
If you are looking to create income with dividends (or avoid them for tax purposes) it’s good to examine what past yields and capital gains distributions have been.
Looking at portfolio turnover can help clue you in to what the capital gains distributions may be in the future.
Types of Index to Mirror:
This is an obvious one, but make sure you are mirroring an established index.
Buying a biotech ETF is not index investing. It’s a mix of index investing and stock picking (gambling). If you want to be in that game, fine.
Otherwise, make sure you are mirroring established indexes (like the S&P 500 or Dow Jones) or indexes that provide diversification (Small Cap Stocks, International Stocks, Bonds, REITs, etc.).
Where You’re Buying your Index:
Last but not least, make sure you are buying your indexes (and all investment vehicles) at a quality broker.
Good means low fees and wide variety. Charles Schwab and Vanguard offer a large variety of funds at rock bottom prices. There are many other great picks similar to those two, as well.
Other brokers charge you every time you trade and may not offer funds with low expense. As we just walked through, expenses can cost you way more than you think.
[PoF: I could have used this post when I started investing in a SEP IRA nearly 13 years ago. Today, I’d choose an individual 401(k) rather than a SEP IRA, but that wasn’t my biggest sin.
I chose funds rather haphazardly, and the collection included an S&P 500 fund with an ER of 0.38%. I could have done worse, but I could have done a lot better!
Thank you to Just Start Investing for sharing the numbers and carts with us today. Better late than never!]
Do you know the expense ratio of the funds you’re invested in? Did you realize that excessive fees can indeed cost you millions?