The Importance of Low Cost Investments
– Russel Kinnel, Director of Mutual Fund Research, Morningstar, Inc.
As an Investor, You Get What You Don’t Pay For
- Extensive research has shown that low cost investments can significantly improve long-term performance. Most advisors, however, still recommend high-cost, actively managed investment portfolios.
- Our approach, which utilizes institutional-class mutual funds and ETFs, reduces the costs of a typical actively managed portfolio by up to 80% (meaning a greater percentage of market returns go to you, the investor).
- Certain asset classes provide clear diversification benefits to the portfolio or deliver access to unique sources of risk with higher expected returns. Thus, it is important to weigh the benefits against the costs.
How a 1% Fee Can Reduce Returns by 25%
Owning a high-cost portfolio is like trying to run a marathon with a heavy backpack on your shoulders. You might be a great runner, but it’s highly unlikely you’re going to win when your competitors left the extra 30 pounds at home.
For example, assume that a fund you are invested in earned 6% last year, before the expense ratio was deducted. If the fund charges a 1% fee, your net return would be reduced to 5% (this is the return that is actually reported to you).
This means that the fund company actually charged a fee that was equivalent to 16.7% of the fund’s return (1% / 6% = 16.67%).
Even worse, compounding magnifies this cost over time (as the above chart shows). After a 30 year investment horizon, the value of the portfolio would be nearly 25% lower as a result of a seemingly innocent 1% expense ratio.
And this comparison actually understates the experience of many investors.
The typical domestic stock mutual fund carries an expense ratio of about 1.35% annually and the typical international stock mutual fund costs a whopping 1.55% a year (per Morningstar, Inc. as of August 21, 2012).
We have long recognized the critical importance of what John Bogle has come to call The Cost Matters Hypothesis (CMH), which states, “Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur.”
For that reason, our approach makes use of low cost investments, including institutional- and advisor-class mutual funds and ETFs, that result in a total portfolio cost of between 0.20% and 0.30% annually.
This results in a cost reduction of up to 80% (or more) compared to a high-cost active approach and puts a significantly greater percentage of the returns back in the pockets of those who took the risk in the first place: the investors.
Don’t Take Our Word For It
– The Motley Fool, a financial services company
Selected Supporting Research
The following is a selected list of research papers, articles, and other sources that form the foundation of our approach to investment management and financial planning. You can access our full research library by clicking here.
Hooke, Jeff and Michael Tasselmyer. “Wall Street Fees and the Maryland Public Pension Fund.” The Maryland Public Policy Institute, April 2012. (Download)
Kinnel, Rusell. “How Expense Ratios and Star Ratings Predict Sucess.” Morningstar FundInvestor, August 2010. (Download)
French, Kenneth R. “The Cost of Active Investing.” Dartmouth College – Tuck School of Business; National Bureau of Economic Research (NBER), April 2008. (Download)
Barber, Brad M. and Terrance Odean. “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors.” The Journal of Finance, April 2000. (Download)
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