Our motto here at John & Jane Doe is “Getting it Together Financially in the Prime of Life.” As that implies, even in my (late) forties I’m still learning money best practices, and I have screw ups I want to share so that other people can avoid my mistakes.
With that in mind, I have a confession to make:
I have paid way too much in mutual fund fees, all because I took way too long to jump on the index fund train.
I have been actively investing for years, and have definite ideas about investing in high dividend yield stocks. I knew what I was looking for and did the research, and for the most part I’m happy with the performance of my stock in companies like Altria and Johnson and Johnson. Between dividend reinvestment and price appreciation, my individual stocks have grown nicely.
I am reluctant to put all my investments in dividend stocks. International and Growth mutual funds and municipal bonds seemed good ways of adding diversification to my portfolio.
That might have been a fine strategy, if I had picked low cost mutual funds.
A decade ago, I had to decide what to do when a company whose stock I owned merged with another. I needed to diversify, and I learned a lot about listening to myself and going my own way when my advisor tried to move me entirely into mutual funds. (You can read about that experience here)
Short version: I made sure I included a good proportion of individual stocks in my investments instead of going with my advisor’s suggestion of moving all to mutual funds.
I still invested some of my money in mutual funds. For the mutual funds, I went along with my advisor’s suggestions. The result?
Expense ratios that ranged from .59 (respectable) to a whopping 2.5% (yikes!). The largest holding had an expense ratio of 1.92%, on a fund that had mediocre returns at best.
I’m not saying that working with the advisor was a bad experience. I did diversify my holdings, picked up some good individual stocks and learned a bit about investing and myself.
Why didn’t he bring the cost of investing into the picture though? Why was I paying so much in yearly mutual fund fees?
What are mutual fund fees and why do you pay them?
Mutual funds take money from a large group of investors and invest it in stocks, bonds, or other investments. Most mutual funds are actively managed. They hire clever managers and analysts to pick the best investments and make trades to maximize the mutual fund’s returns. The mutual fund company passes the capital gains and investment income along to investors, proportional to the investor’s holding.
Mutual funds have advantages. An individual investor can purchase a mutual fund at a relatively low price point. This allows the investor to purchase a highly diverse range of investments that they otherwise might not be able to afford, reducing their investment risk. Mutual funds also benefit from economies of scale and are highly liquid.
Mutual funds mean you can be an investor without knowing a lot about investing. You’re going to pay someone else to make investment decisions for you. The problem is, that can get expensive.
Mutual fund companies make their money through fees. Most have loads (transaction costs) when you buy and sell shares. Mutual funds also have annual expense ratios, ongoing fees that investors pay to participate in the funds. Expense ratios are the bulk of mutual fund fees and cover:
- Management and staff salaries and bonuses
- Administrative costs
- 12B-1 fees, which cover brokerage fees and commissions and advertising for the fund
When you’re buying mutual fund shares, you’re paying someone to make investments for you to get the best possible return. Getting a return that beats the performance of the total market takes expertise, analysis, and more than a little luck. A mutual fund manager that can do that commands big bucks.
Unfortunately, so do the managers that don’t.
What’s the alternative?
I’ve been reading Jack Bogle’s Little Book of Common Sense Investing, which is his treatise on his contribution to investors everywhere: the index fund. Bogle founded Vanguard in 1974 and started the first S&P 500 index fund the next year.
The principal behind the index fund is you hold a microcosm of the stock (or other) market. If the market goes up, so does the value of the index fund. If the market goes down, so does the value of the index fund.
The difference between an index fund and a traditional mutual fund is that a mutual fund is actively trading stocks (or bonds) to try to beat the market. That would be great, if actively managed funds could do that consistently and reliably.
The vast majority don’t. A 2010 study found that the number of active managers that beat the market is about what you’d expect from chance alone.
Even the best mutual funds only manage to beat the market for a short time. It’s just too hard to make good bets consistently. Bogle’s innovation was to say, “If investors can’t beat the market, they should just own it”.
An index fund isn’t trying to beat the market, just to mimic it. It doesn’t need to pay clever analysts tons of money and huge bonuses to make winning picks. It’s not racking up tons of transaction fees by buying and selling stock all of the time.
An index fund is not doing the things that generate high mutual fund fees, therefore it can charge low fees.
Really low fees. I found an index fund to invest in whose fees were less than one-tenth the cost of the cheapest fund my ex-advisor recommended.
An index fund beats most mutual funds in performance AND costs less?
Jumping to Vanguard’s Admiral Shares
Point made. Understood.
I may be still trying to develop a basic frugal mindset, but I understand that paying more for an inferior product doesn’t fit my current mindset.
I’m not getting rid of my individual stocks. I still like buying and holding dividend stocks and building the portfolio through reinvestment. It’s been a successful strategy for me.
That may be because I was comparing them to the performance of those overpriced mutual funds. Maybe I’ll change my mind later, but for now, I’ll keep my MO et al.
I’m done with actively managed funds, though. I’m selling them all, a little bit at a time, and moving to index funds. I did this with my Roth IRA this summer, and I’m in the process of getting rid of the actively traded mutual funds in my Vanguard brokerage account.
The plan now is to trade out of the active funds over the next year and replace them with Vanguard 500 Index Fund shares. The basic Vanguard 500 Index Fund has an expense ratio of 0.17%. Since I had at least $10,000 to invest, I was able to get Admiral shares, which have an expense ratio of .05%.
Instead of paying $25 or even $5.90 every year in mutual fund fees for every $1000 invested, I’ll be spending 50 cents.
I’m open to moving some money into other index funds, though. I like the idea of keeping some funds in the international market or investing in a bond index. Vanguard bond index funds have expense ratios around 0.20%, and most of their international funds tend to be in the 0.15-0.45% range. They’ll provide some diversification with only slightly higher fees. With interest rates sure to rise, now may not be the best time for bonds or bond funds, though.
Whatever I do, I’m sold on index funds. No more outrageous mutual fund fees for me.
Finally, I’m convinced that trying to beat the market through actively managed mutual funds is like trying to find weight loss without exercise: a short-term possibility but a long-term road to failure.
Have you made (or almost made) investment decisions that you regret? What factors do you look for in making your investment choices?
This article is for informational purposes only I am not an expert. If I was, I might have made better choices. Then again, maybe not.
First published 11/16/15, updated 1/26/17