Paying More in Fees Can Get You Less in Returns

I recently reviewed the portfolio of a young man who had inherited almost $1 million. He had entrusted his funds to a large mutual fund company. He thought his portfolio was "well diversified" because almost all of it was invested in an S&P 500 Index Fund. Several issues were apparent, which you might be able to relate to your investments.

He was paying a 1% "management fee" to the fund family for providing him with investment advice. His advisor purchased an S&P 500 index fund with an expense ratio of 1.50%. Added together, he was paying 2.50% of his assets to invest in an index fund that could be purchased from Vanguard for 0.17% (Vanguard 500 Index Fund Investor Shares [VFINX]). By doing so, he would reduce his fees from 2.50% to 0.17% since he would eliminate the management fee as well.

The expense ratios of S&P 500 index funds range from very low to extremely high. For an egregious example of an indefensibly high expense ratio, consider the State Farm S&P 500 Index B (SNPBX). It has an expense ratio of 1.49%, and a deferred load of 5.00%. This fund has assets of $547 million.

A small difference in expense ratios can have a dramatic effect on returns. Let's assume an S&P 500 index fund and Vanguard's both return 8% annually, before costs and you invest $10,000. A savings of only 1% annually on expenses would mean the lower cost fund would yield an additional $63,000 over forty years ($201,000 versus $138,000). That's a big difference.

There are other problems with the underlying assumption that buying an S&P 500 index fund is sufficient diversification. It omits bonds, which should be included in most portfolios. It also omits exposure to international markets and to thousands of mid-cap and small-cap stocks. If you are interested in putting together a globally diversified portfolio of low management fee index funds, you could consider Vanguard's Total Stock Market Index Fund (VTSMX) for exposure to the domestic stock market; Vanguard's Total International Stock Index Fund (VGTSX) for exposure to the international stock market and Vanguard's Total Bond Index Fund (VBMFX) for the bond portion of your portfolio.

While index funds are typically lower cost than comparable actively managed funds (where the fund manager attempts to beat a designated benchmark, frequently without success), there can be a big difference between index funds tracking the same index. Check the expense ratio carefully before you make a final decision.

Dan Solin is a Senior Vice-President of Index Funds Advisors (ifa.com). He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.