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Investing Strategy Part 3 – Use Low Cost Mutual Funds

In earlier posts, I discussed the first two keys to a successful investing strategy:

Key 1 – Be Risk Appropriate

Key 2 – Be Well Diversified (by using mutual funds)

Key 3 is to Use Low-Cost Mutual Funds to increase your returns.  The impact of investment costs is never emphasized enough. In order to see how much it affects mutual funds returns, let’s compare a few different domestic stock mutual funds:

Fund A: A Total Stock Market Index Fund which charges no sales load and has an annual expense ratio of 0.15%.

Fund B: An actively managed Mutual Fund with a 5.75% sales load and an annual expense ratio of 0.59%.

Fund C: An actively managed Mutual Fund with no sales load and an annual expense ratio of 2.03%.

In other words, Fund A is no-load, with low costs. Fund B does charge a sales load, but it has fairly low annual costs. And Fund C charges no sales load, but it has substantially higher annual costs.

Assume that you invest $10,000 in each of these funds and that over the next 30 years the market earns a 9% annual rate of return and that both of the actively-managed funds (B and C) end up being exactly average. That is, their before-expense returns over the period are equal to the market return (which is a very realistic assumption).

The investor in each fund would end up with the following amounts:

Fund A $127,307

Fund B $106,258

Fund C $75,485

That’s a significant difference!

On a $10,000 initial investment, you will have paid an extra $50,000 over 30 years for the high-cost fund.

An investor in Fund A would have almost 70% more money than an investor in Fund C. This example shows that costs really do matter!

A 2% annual expense may seem small. But over an extended period of time, it can absolutely crush your returns.

It also shows that paying a sales load obviously doesn’t help your results, but for long-term investors, annual expenses have an even greater impact.

 You may wonder if the higher expenses will get you a higher return. The answer is NO and this has been demonstrated over and over by actual return data over the years.

This phenomenon is explained by the “efficient market hypothesis”, first developed by Gene Fama.

While other thinkers had long questioned whether stock prices were really predictable, Fama’s work gave the efficient-market hypothesis its most rigorous intellectual grounding (as well as its name). Fama argued that the stock market is a matchless information-processing machine, whose participants collectively price shares correctly and instantaneously. Unlike the market portrayed in mutual fund advertisements and personal-finance magazines, it is not a place where the smartest managers outwit the less smart. Instead, the market is so full of well-trained, well-motivated investors avidly gathering information and acting on it that not even Nobel Prize winners can hope to beat it consistently.

Sure, some managers will outpace the market for a few years, but it is impossible to prove that those runs are more than just sheer chance. The efficient-market theory still raises hackles on Wall Street, for obvious reasons.

But in academia the debate is all but over, and among pension fund fiduciaries Fama’s theories are now so accepted that an estimated 24% of the trillions of dollars in pension assets is invested in index funds.

The bottom line – control your costs and reap the rewards.

Passively managed funds, such as index funds, are the best way to do this.

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