If you really want to make some serious money by investing in mutual funds, don’t you think it’s a good idea not to give more of it away to people who will happily take it from you–if you allow them to?
“What do you mean?” you ask.
Well, what I’m referring to is a fund’s expense ratio, which is a fee that you’re charged each year in order to manage the fund. And the way it works is that the fee is calculated as a percentage of your assets. For instance, if your fund has a 1 percent expense ratio and you have $10,000 in your portfolio, you’d pay $100 every year in fees.
Now, although most funds charge this fee, there’s a vast difference in the amount you’ll pay based on the type of fund you invest in. And to be more specific, there are two types of funds that you can own: actively managed funds and index funds. Let’s go over them briefly.
With actively managed funds, the fund manager analyzes and picks investments in order to try and exceed the results of a benchmark or index which measures changes in price, such as the S&P 500. Doing all of this, however, results in greater costs, and those costs are passed along to you in the form of higher expense ratios.
On the other hand, with index funds, the manager doesn’t pick investments. Instead, a computer simply matches the results of the index.
And as a result, managing an index fund is much easier, which makes it more cost effective for you to own. In other words, more of your money works for you instead of getting deducted each year in order to pay for the expensive fund manager and other expenses.
You see, when it comes to making money by investing in mutual funds, unnecessary and excessive fees are your enemy. That’s why every dollar that you save is a dollar that’s added to your pocket books.
So, with all that said, let’s look at fund results from two different sides: 1) the fees you pay, and 2) the growth rate you get. First, we’ll compare the fees for an index fund with those for an actively managed fund.
Let’s say you have the choice between investing in an actively managed fund which charges a 1 percent expense ratio or an index fund with a 0.08 percent expense ratio. Based on the type that you choose and the amount of money you have in the fund, the table below shows how much you’ll pay each year in fees.
| Size of your portfolio | You pay this much each year in a low-cost index fund with a 0.08% expense ratio. | You pay this much each year in an actively managed fund with a 1% expense ratio. |
| $5,000 | $4 | $50 |
| $25,000 | $20 | $250 |
| $100,000 | $80 | $1,000 |
| $500,000 | $400 | $5,000 |
| $1,00,000 | $800 | $10,000 |
So, would you be okay with paying thousands of dollars each year in fees? Or would you rather spend much less?
Ok. Now, if you still don’t think that these seemingly minuscule expense ratios matter, let’s look at how fees affect the amount of money you make.
Again, suppose you have the choice between investing in an actively managed fund which charges a 1 percent expense ratio or an index fund with a 0.08 percent expense ratio. Both funds grow at a rate of 8 percent each year, and you invest $4,000 each year into one of them. Based on the fund that you choose, the table below shows how much money you’ll have after various time periods.
| If your money grows by 8% per year and you invest $4,000 each year, | In a low-cost index fund with a 0.08% expense ratio, | But in an actively managed fund with a 1% expense ratio, | You lose this much in fees with an actively managed fund. |
| After 10 years, you have . . . | $62,287 | $59,001 | $3,286 |
| After 20 years, you have . . . | $195,728 | $174,631 | $21,097 |
| After 30 years, you have . . . | $481,606 | $401,244 | $80,362 |
| After 40 years, you have . . . | $1,094,056 | $845,363 | $248,693 |
Here, you end up paying hundreds of thousands of dollars more because you own an actively managed fund. So, in this case, choosing a high-quality, low-cost index fund instead of an actively managed fund that charges unreasonable fees makes the difference between becoming a millionaire after a lifetime of investing and falling short of that goal.
And that’s not all. You see, this example assumes that both index funds and actively managed funds grow at the same rate. But studies have shown that over the long term, nine out of 10 actively managed funds fail to beat their benchmark index.
Or, to put it another way, index funds get better results than an overwhelming majority of their actively managed competitors. So, you probably lose even more money by using an actively managed fund.
