Fees and expense ratios are some of the most poorly understood and (unfortunately) most impactful elements to long-term investing success. While someone investing at all is ahead of the curve, we must be fully aware of the corrosive impacts of the expense ratio and other fees.
This week we explain common sources of fees and analyze just how much they are costing us. Are you paying a financial advisor? We’ve got you on this one!
Let’s go!
Comparing Index Funds: Performance AND Fees
I get a lot of emails or other comments asking my thoughts on index fund X, Y, or Z. Despite my dogged persistence about my favorite index fund, VTSAX, I’m still often asked about other mutual funds. Now, certainly, part of this could be explained by the typical American 401(k) account, or other similar pre-tax retirement buckets. Precious few of these accounts offer VTSAX, so I suppose a number of readers are trying to do the best with what they have. I get that, and I was in the same boat at one point.
Or, perhaps as was the case with a recent reader, they are holding a managed fund that, while laden with a higher fee, has outperformed the market over some sort of reasonable timeframe.
First, I’m going to assume you are interested in a broad-based index fund. If you only invest in one fund, avoid words like “growth” or other enticing phrases that translate to flash-in-the-pan performance. We want sustainable growth, so any equity-heavy mutual fund that essentially tracks the S&P 500 is winning. That said, performance is far from the only important factor when assessing an index fund.
How else can we compare apples and orangutans? The next step is to assess the expense ratio.
Fee Source Number 1: The Expense Ratio
My first recommendation, assuming I’m not being asked about bitcoin or perhaps GameStop, is to look at a given fund’s expense ratio.
Where do I do this? I use Morningstar, an online market research firm*. I simply go to the search box (top-left at time of writing), type in a company name or stock ticker, and let Morningstar spit out shining (morning?) stars.
If I punch in “VTSAX” into the search function, I immediately get some really useful data on the “Quote” tab. Most relevant to this discussion is the expense ratio.
What is an Expense Ratio?
Simply put, an expense ratio is the fee that the hosting organization must charge for administrative and other operating expenses. Someone, after all, has to build and maintain the index fund, weighting each company based on market cap. For example, VTSAX is currently composed of 3,628 individual companies, some of which will grow, and some of which will one day cease to exist. We pay Vanguard a small slice of our earnings for this curation service.
We can see that Vanguard charges an expense ratio of 0.04%. That’s pretty much as good as it gets.
* As a passive investor, I see no reason to go beyond what Morningstar offers for free, a simple database of individual stocks and mutual funds. One can pay for more in-depth analysis and ratings, perhaps suitable to an active investor, but I wouldn’t. I also have no affiliation with Morningstar.
How Do Expense Ratios Compare?
If we flip over to the “Price” tab in Morningstar, we see a series of charts comparing the expense ratio of VTSAX to the category (Large Cap) average and a comparison group. In simple terms, the VTSAX expense ratio (“Fund”) is indeed far below that of the competitors, which typically hover in the 0.7% – 1.0% range.
Other mutual funds might carry an expense ratio between 1.0% – 2.0%, but rarely exceed 2.5%.
This all seems inconsequential, right?
Financial advisors have done a stand-up job for decades of convincing well-meaning folks that investing and retirement saving is too complex for the average Joe.
Other Fees: The Financial Advisor
Beyond the expense ratio, which is carried by every mutual fund, we must carefully assess the utility of the once sacred cow: the financial advisor.
In the post, Financial Advisor: Who Needs One?, we reviewed a number of misconceptions on the necessity of a financial advisor. Furthermore, we see how much money they can actually be costing us.
Financial advisors have done a stand-up job for decades of convincing well-meaning folks that investing and retirement saving is too complex for the average Joe. Therefore, tragically, two outcomes often occur when a financial advisor is hired:
- The advisor constantly shuffles the client in and out of funds aimed at “outperforming the market.” Run if you ever hear this. In doing so, the advisor often underperforms the market, and collects loads of commissions, fees, and taxable events with all the shuffling. How many transactions have occurred in the last year with your financial advisor? How is your total equity performance comparing to the S&P 500 over the last 10 or more years? Greater than 80% of actively managed funds underperformed the S&P Composite 1500 from 2008-2018.
- The advisor charges an assets under management fee (AUM). Even a commission-only advisor with a 3% fee will crush your long-term ambitions of a sturdy retirement, as we will soon see. Add in the shuffling mentioned above, and you have a recipe for a less fruitful retirement.
I’m not here to say that all financial advisors are evil sharks lurking in warm, shallow waters. A fee-only advisor who acts with a fiduciary duty to offer occasional guidance at an hourly rate could be very appropriate for planning purposes. But at all costs, avoid commission-based advisor services.
Do you want to use your retirement dollars to pay for someone else’s retirement?
Why Does the Expense Ratio and Fee Structure Matter?
It’s easy to think, “So what CC!? Why should I care if I have to give up 1% or 2% of my earnings? I’m still keeping 98%-99% of my scrilla!”
That’s not how it works. We don’t simply subtract an expense ratio or other fee from 100% of earnings.
We subtract that expense ratio from our yearly return.
A Note on Long-Term Returns
For instance, I always use an expected yearly return of 7% for VTSAX, because VTSAX is a proxy for the market as a whole. At the time of writing, VTSAX has a 15-year nominal return of 10.22%*, consistent with the long-term average return of the S&P 500 (source). Accounting for inflation, on average around 3%**, we arrive at a long-term, inflation-adjusted average yearly return of 7%.
*Important Note: A 10% nominal return (before inflation) is an approximate long-term average of historical data. This is not the expected return for any given year. We subtract 3% for inflation to arrive at a long-term inflation-adjusted return of 7% per year.
**The current inflation rate at the time of writing is ~2%, but let’s just be conservative and round up to 3%. Here is some historical inflation data.
Calculating a Real Market Return
So, to assess the impact of an expense ratio on VTSAX, I’m going to subtract that 0.04% from my expected long-term (inflation-adjusted) return of 7%, to give me a real return of 6.96%. I’ll take it!
Real Return = Market Return (Inflation-adjusted) – Expense Ratio – Other Fees (advisor, etc)
VTSAX Real Return (individual DIY investor) = 7% – 0.04% = 6.96%
Comparing Different Levels of Expense Ratios and Fees
Let’s compare another index fund with an identical inflation-adjusted return of 7%. The only difference is that this fund has an expense ratio of 1.0%. No big deal, right?
New Fund Real Return (higher fee, DIY investor) = 7% – 1% = 6%
What if this fund has a 2% fee and is managed by a financial advisor who also charges a 2% assets under management (AUM) fee?
New Fund Real Return (higher fee, advisor managed) = 7% – 2% – 2% = 3%
How does that fare over a 40-year investing horizon with a $10,000 investment?
Even though each fund has a theoretical 7% yearly inflation-adjusted return, the unlucky fellow who had a financial advisor pick a high expense ratio fund (the 4% fee guy) returned ONLY 22% of the 0.04% fund DIY gal!
Don’t let fees interfere with The Wondrous and Fantastic Power of Compound Growth.
Bottom Line: Something as seemingly insignificant as a few percentage points can crush your returns by hundreds of thousands—perhaps even millions—of dollars. This could quite literally be the difference between abundant wealth and a retirement spent in worry (or none at all). Real talk: take the expense ratio and other fees seriously.
…We absolutely must take our brains out of the equation, finding the laziest, simplest, and least obtrusive path to investing. Otherwise we won’t do it.
VTI Vs VTSAX: A Subtle Expense Ratio Difference
Folks have recently noted that VTI, the ETF-equivalent of VTSAX, now carries a 0.03% expense ratio. Is it worth switching from VTSAX for VTI for the lower expense ratio?
For all intents and purposes, VTI and VTSAX are exactly the same. VTI is an ETF and VTSAX is a mutual fund. I don’t want to bog this post down with the differences between ETFs and mutual funds, but here is Vanguard’s common ETF questions.
The Importance of Automatic Investments
Here’s the primary difference in my simple mind: You can’t easily set up automatic contributions with an ETF. Because we know that regular and automatic investments are the cornerstone to building wealth, we absolutely must take our brains out of the equation, finding the laziest, simplest, and least obtrusive path to investing. Otherwise we won’t do it.
I’ve heard that various robo-advisors like M1 finance and Betterment now make automatic investment with ETF’s easier. However, I also know that these services offer lucrative affiliate programs to the bloggers and podcasters who promote them, so I follow the incentive trail and am left dubious and queasy after eating a lot of breadcrumbs. I’m still a John Henry kind of guy: I like simple systems that I can implement.
How to set up automatic investments with Vanguard.
For my money, the difference on a 0.04% and 0.03% expense ratio is basically negligible. I’m sticking with my tried-and-true automatic investments with VTSAX. You do you.
One final note: VTI has a considerably lower minimal investment requirement. VTSAX requires a minimum investment of $3,000, while VTI only requires the cost of one share (currently $204 at the time of writing). If you don’t have $3,000, VTI can be a great place to get going. I’d personally make the switch at $3,000.
Zach over at Four Pillar Freedom did a fine review: VTI vs VTSAX: What’s the Difference?. Note: at the time both funds still carried a 0.04% expense ratio.
For more on why we are so jazzed on VTSAX, check these out:
The CC Family Investing Strategy: Part 1
The CC Family Investing Strategy: Part 2
Today’s Action: Look at Your Expense Ratio!
Stop whatever you are doing and go take a gander at your expense ratios and fees. Are you in mutual funds or index funds with high expense ratios? Are you with a financial advisor who is building their retirement on your retirement dollars?
Find index funds with expense ratios less than 1%, and the lower the better (<0.05%). Focus on funds that represent the broader market. For US investors, I’d look for words like “whole market,” “total market,” or “S&P 500” in accounts where I don’t have many choices (401(k), etc.). In a Roth IRA or brokerage account, we really like VTSAX. This is not advice (disclaimer), I’m just telling you what we do! These are funds which track the market as a whole and offer some of the lowest expense ratios available.
What’s not to love?
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Thanks guys, see you next week.
This is so important. Thanks for sharing. Warren Buffett reminded us all that paying just 1% over 80 years will cut your money in HALF. And, your table shows that a 2% fee cuts your money in half in 40 years (~$140k vs ~$70k). Fees matter!
Great summary! I hadn’t connected the dots on that statistic.
Solid article on the fundamentals of some basic investing concepts.
Thanks for that!