Tale of 2 401Ks – Why Expenses Matter

We need to talk a little bit about investment expenses. Those of us who plan on enjoying our “golden years” will save money for retirement. The majority will use mutual funds as our go-to investment vehicle. (We will spend much more time on this later on). While people spend a lot of time looking at the return one mutual fund has historically offered over another, they tend to spend far too little time looking at expenses. Lets face it, past performance doesn’t guarantee future returns – we cannot do much about how the markets perform – but expenses we can control. Lets dive a little more into this and look at Sally and Mark (not their real names 🙂 ).  Both work in corporate veterinary medicine and their company’s 401K offers a wide arrange of investment options. Sally decides to invest in a combination of no-load low cost index mutual funds from a well known investment company while Mark decides to go with a managed “lifecycle fund”. They both manage to earn 6% but when they go to retire, Sally (blue line) has $128,000 more than Mark (Red Line) – what happened?

Why managed funds aren’t worth the expense

First of all, lets dispel an important myth, “you get what you pay for.” On Wall Street nothing could be further from the truth. Perhaps Mark Hanna in the Wolf of Wall Street said it best “Number one rule of Wall Street. Nobody… and I don’t care if you’re Warren Buffet or if you’re Jimmy Buffet. Nobody knows if a stock is gonna go up, down, sideways or in fucking circles. Least of all, stockbrokers, right?” If you haven’t watched this movie – you really need to. You will never look at the financial industry the same way again. Be forewarned,  its NSFW (or an airplane).

By their very nature, so-called managed funds have higher costs than “index funds.” In a managed fund “experts” try to buy stocks and or bonds that will maximize return to the fund shareholders. In order to compensate these so called “experts”, the fund shareholders pay management fees. This is reflected in the fund’s expense ratio. The expense ratio is the total percentage of fund assets used for administrative, management, advertising, and other expenses. So an expense ratio of 0.5% means that each year the fund will take 0.5% of a shareholder’s funds and use them to cover expenses. So if you invest $100,000 in a mutual fund and the expense ratio is 0.5% the fund will come along and take $500 of your money each year to cover their expenses. Sounds fair enough – except there is little evidence that managed funds actually perform better than unmanaged index funds which have lower expense ratios. In fact, according to one recent study by S&P Dow Jones Indices found that over the 10-year time period, 82.14 percent of large-cap managers, 87.61 percent of mid-cap managers, and 88.42 percent of small-cap managers failed to outperform their index benchmarks. There are many other studies that draw the exact same (or worse) conclusion. So essentially the vast majority of people who invest in managed funds pay more and get less. In the example above, Mark invested in fund that returned the same 6% as Sally’s fund but had higher (0.66 vs. 0.14%) expense ratio (Vanguard stock vs TIAA lifecycle fund). In the real world, Sally would probably pay less AND get a higher return. Compelling evidence that index funds are the way to go!

Index funds are relatively unmanaged funds that invest somewhat robotically in some broad market indices such as the Standard & Poor’s 500. Because we don’t need to pay expensive experts, the expense ratios tend to be lower. In the example above, I used the Vanguard Total Stock Market Index Fund. This fund is designed to provide investors with exposure to the entire U.S. equity market, including small, mid, and large cap growth and value stocks. It does this with a low expense ratio of 0.14%. Because of this, Sally retires with $128,000 more than Mark and that will pay for quite a few vacations or provide a down payment on a summer home or…..

The moral of the story folks is that we cannot control the market but we control expenses. When looking at an investment we need to look not only at the return but the expense. Lastly I hope I have made a compelling argument against blindly putting your money into managed funds. Managed funds enhance the lifestyle of the managers while taking money from their  investors retirement. Index funds are the way to go.

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