Fund expense question

[plow_2]

So every writer/blogger that recommends Vanguard index fund investing points out the low expense ratio. I've also read articles that point out that the extra money spent on expenses compounded makes a huge difference. Now according to investopedia..."Operating expenses are taken out of a fund's assets and lower the return to a fund's investors"

This makes is sound like I'm not actually being charged a fee and I've never seen a fee come out of my retirement accounts either. So when I'm looking at fund performance, is that value (say 23% for example) after expenses. And if that's the case, if I'm looking between an index fund or say a blue chip growth fund that's made 10% more, I'm better off with the growth fund (as far as profit is concerned). Also if that's the case it seems disingenuous to push the low expense ratio of an index fund as a good reason to invest in it. I think there are plenty of other good reasons for index investing but the expense ratio doesn't seem to be one. Am I missing something?

[DutchGirl]

The recent return of a fund does not mean that this return will continue to exist. Most positively outperforming funds will return to average results over time. People buying last-year's best performing fund will probably buy a fund that will not perform as well as it did last year.

There are a very, very few mutual funds who currently have an active manager who will steer this fund towards higher than average profits in the future - and so many more profits that they're worth the extra fee. However, there are more mutual funds who will underperform compared to index funds - or perform the same as index funds - and you'll still pay the hefty fee.

You and I are not able to tell which active manager of a mutual fund will be the one who will perform best in the next 5, 10 or 30 years.

So I am not investing in active mutual funds, no matter their latest 1, 5, 10-year or from-start returns.

[jacob]

@plow_2 - The total return you see is net of operating expenses (management, records, accounting, website, ... ) and marketing expenses (12b-1 ... which is often zero). E.g. if a fund's total return is listed as 10%, then you got 10%. If the fees are listed as 2%, then the fun really returned 12% and you get 10% and paid 2%.

A fund may also be sold as a load or no-load fund. If the fund has a 5% load, then if you invest $100, then you only have $95 going into the account with the broker taking $5 for the "service" ... kinda like how a RE agent gets paid when they sell a house. If your fund has a total return of 10%, a load of 5% and a fee of 2% and you invested $100, then you'll see $95*1.1 = 104.5 in your account. If it returns 10% again, you'll see 104.5*1.1=114.95 the year after since you only pay the sales charge once. There are of course also the possibility of redemption fees.

Fees may be thought of as a headwind. If a fee is 1.2%, then the manager has to beat the index by 1.2% each year just to get back to the starting block. Another manager with a fee of 0.6% would only have to beat it by 0.6% and so on. When we're talking index funds, you're only paying for the records, ... so in that case, the fees are practically the only thing they can compete on...

HOWEVER, one kind of "fee" that's generally not listed until recently is the spread and slippage which has to do with trading implementation. These costs can sometimes be large (especially for bond funds). IIRC, funds are now required to list those as well, at least in the EU. These costs will be larger in portfolios (and funds) with high turnovers.

In terms of performance, index funds tend to outperform active managers in trending markets, e.g. 2009-2017 (it's very hard to beat something that's going up and up without using leverage or risk) and active managers tend to beat index funds when the market is going sideways (trading range) or down, e.g. 2000-2008.

[DutchGirl]

active managers tend to beat index funds when the market is going sideways (trading range) or down, e.g. 2000-2008.

...Except that the active managers from my chosen mutual fund panicked and sold most of the stocks in my actively managed mutual fund after the damn stock market already had tanked. Thanks a lot, folks. That's when I sold my shares of that fund and started investing in index funds, where I can have and maintain my own preferred balance between stocks and bonds.

In short: there are smart mutual fund managers and there are also stupid ones. And oh, let's also not forget the factor of (bad) luck.

[arcyallen]

Plow_2 - The ongoing performance of a mutual fund will ALWAYS reflect the ongoing internal fees. You'll never see the performance without it (except like Jacob said with the possible up front one-time A share commission of 0-5.75%). And you'll never see it on a statement, but you will see it on most marketing material. So yes, a 10% return is a 10% return is a 10% return.

I'm a big fan of "Value over price". It's not what you pay (.04% or 1.4%), it's what you get out of it. It's true that the active fund lags the market. But you're not ever buying "the average fund", you're buying a specific fund. There ARE funds that consistently beat the market for long periods of time. How they did last year, or even the last five years, is actually pretty irrelevant as luck plays a big role in the shorter term. How they did over the last 10...20...40 years is much more relevant and reflects the skill of the managers.

If you can find a fund that buys high quality investments, stays focused/diversified, and holds them for the long term, that fund will generally turn out alright - especially if they can go against the crowd while doing it. (DutchGirl's fund is an example of how NOT to do it - selling because things went down is usually not going to work out well.)

[ThisDinosaur]

In terms of performance, index funds tend to outperform active managers in trending markets, ... and active managers tend to beat index funds when the market is going sideways (trading range) or down.

Isn't this almost entirely dependent on asset allocation? IOW, an active fund with a bond allocation will outperform a stock index fund when bonds are doing better than stocks.

[arcyallen]

I think the point here is that a good actively managed fund (apples to apples, stock vs stock) outperforms an index when things are going down or sideways more so than when things are going up. When markets are on fire it's extremely hard to beat an index. This past decade is a great example - even the best active funds are just matching the index.

[plow_2]

Thanks everyone, I appreciate the input. To put things in perspective I'd been investing in different funds on my own in my 401K, diversifying in healthcare, technology, blue chip growth, etc etc. Then after reading several books touting index funds I added them as well but the argument about their low fees struck me wrong. JL Collins has a calculator where you plug in two fund expense ratios and it shows how much it hurts growth; only it only applies if both funds had the same returns. I'm in no way discouraging index funds and I'm still investing in them now, only that the expense ratio argument is flawed and in my opinion misleading. If I chase lower expense ratios then I may lose out on higher returns in better performing funds, albeit at the expense of increased risk. This is how I understood this situation but the index fund only books and several co-workers who misunderstood them cast doubt on my understanding. It's nice to know that I'm right. I'm always right...sometimes.

[arcyallen]

JL Collins has a calculator where you plug in two fund expense ratios and it shows how much it hurts growth; only it only applies if both funds had the same returns.

Yes, and if you try to tell those same people that, they'll shun you and ridicule your very solid -facts- because it conflicts with their -opinion-. It's why I stopped visiting most forums. Even the FINRA website, which should be "above the fray" when it comes to indexing, does the same thing. Plug in the world's best active fund against the worst similar index fund, and the index fund magically comes out ahead.