This post is a brief reminder about the need to understand and control investment costs in your retirement portfolio. Costs of investment include transactional costs (e.g., buying and selling commissions), maintenance costs (account and advisory fees), and fund expenses.
Investing Costs and Historical Performance
Some people sub-consciously associate higher costs with better performance in both products and services. That is definitely not the case with investments.
The Journal of Finance published an article in the ’90s that established: (a) the best-performing fund managers were not increasing their fees based on better performance; and (b) high fees were often associated with inferior fund performance. Also, the article showed that the worst performing funds (after expenses) also had the highest investment costs. (Source: M. Gruber, 1996, “Another Puzzle: The Growth in Actively Managed Mutual Funds,” Journal of Finance 52: 783–810.)
Other published reports had similar conclusions. Similar studies found that low-cost mutual funds had better than average performance in every period evaluated. (Source: Mark Carhart, 1997, “On Persistence in Mutual Fund Performance,” Journal of Finance 52 (1): 57–81; and Financial Research Corporation, 2002, Predicting Mutual Fund Performance II: After the Bear (Boston)). Another paper suggested that cost is the most significant factor in long term returns from mutual funds. (Source: Phillips and Ambrosio, 2008, “The Case for Indexing,” Vanguard Investment Counseling & Research.)
Finding Low Cost Investments for Retirement
Probably the easiest and fastest way to find low cost investments is to use a fund family that specializes in them. Yet another article tells us that no-load equity and bond fund families in the lowest 20% cost category had more index-beating funds than those in any higher expense range. (Source: Clark, 2004, “How well do Expenses and Net Returns Predict Future Performance?” Lipper Research Study)
I use Vanguard funds (mutual and exchange-traded) for most of our retirement investments. In 2008, Vanguard funds had an average expense ratio of 0.20%. The industry average was 1.19%. That’s a difference of about $100 per year, for a $10,000 investment.
So, if you have $500,000 in your retirement portfolio, the investment expense difference between funds having average expenses and low cost funds such as those from Vanguard would be approximately $5,000 annually. Compound that over 10-20 years and you are talking some serious money.
Need I say more?
Photo credit: James Ashburn