The #1 predictor of investment performance is expense!

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. 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. Let’s face it, past performance doesn’t guarantee future returns. We cannot do much about future market performance, but we can control expenses.

Tale of 2 retirement accounts

Let’s look at two DVMs, Sally and Mark.  Both work for a veterinary practice and their practice offers a “Simple IRA” (Savings Incentive Match PLan for Employees) which offers an array 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 popular actively managed fund. Both manage to save $250 a month for the entire length of their career. They both manage to earn 6% on their investments but when they go to retire, Sally (blue line) has over half a million dollars while Mark has less than $400,000! What happened?

Managed funds aren’t worth it

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 f**king 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.

Why do managed funds cost more?

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 charges shareholders a management fee. 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. In managed funds, these fees typically run 1.0% – 2.5%. So an expense ratio of 1.0% means that each year the fund will take 1.0% of a shareholder’s funds and use them to cover expenses. If you have $100,000 invested in a mutual fund and the expense ratio is 1.0% the fund will take $1,000 each year to cover their expenses. They do this in theory because they will more than make up for it by actively picking the best investments. Sounds fair enough, except there is little evidence that managed funds actually perform better than unmanaged index funds. And index funds have much lower expense ratios.

According to a recent study by S&P Dow Jones, over a 10-year time period, almost 85% of fund managers failed to outperform their index fund counterparts. There are many other studies that draw the exact same (or worse) conclusion. Essentially, the vast majority of people investing 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 expense ratio. In the real world, Sally would probably pay less AND get a higher return.  Compelling evidence that index funds are the way to go!

What are index funds?

Index funds are relatively unmanaged funds that invest somewhat robotically in some broad market indices such as the Standard & Poor’s 500. Because they don’t need to pay expensive experts, the expense ratios tend to be much lower. Often as little as 0.02%, and in some cases 0.0%. In the example above, Mark paid a typical 1% expense ratio while Sally paid 0.02%. Because of this, Sally retires with ~$129,000 more than Mark and this will pay for quite a few vacations or provide a down payment on a summer home!

The moral of the story is that while we cannot control the market, but owe it to ourselves to control expenses. When looking at an investment, DVMs need to look not only at the return but more importantly expenses. I hope I have made a compelling argument against putting 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.