One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio. In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small. Over long periods of time, however, the ups and downs of the market tend to average out. The effect of those costs however is persistent and continuous.
There are a range of costs associated with investing in funds beyond the stated expense ratio. In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds. Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising. He has written similar pieces in the past. In this article, he provides updated numbers, backed up by a range of academic analysis. His summary of costs is provided in Table 1 of his article:
There are three types of expenses, in addition to the standard expense ratio. First are transaction costs, which are simply a fund’s trading costs. This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses. Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds. He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio. The second source of additional cost for active funds is cash drag. Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash. To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance. Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year. The final additional cost that Mr. Bogle includes is sales charges / fees. This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees. Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate.
When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year.
The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference. The ICI also reports that the most expensive funds can have much higher expense ratios. They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%.
Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year. This number is highly uncertain. The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%. A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%. Because of compounding, the long-term impact of these costs increases over time.
The average costs from Mr. Bogle’s article are not unreasonable. There are probably many investors paying this much or more. On the other hand, there are plenty of investors in active funds paying considerably less.
Where does all of this leave investors? First and foremost, it should be clear that costs matter a great deal. There will always be expenses associated with investing, but they vary widely. Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings. Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio.
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