Expense Ratio and Annual Return

[GreanBrain]

Hello FIRE friends,

I'm extremely happy to finally join this community and I'm excited to post my first topic. I have been catching up on a lot of readings including Mr. MMM, JL Collins, etc. One thing that I'm convinced of is that I should be investing in index funds and should be looking for a low expense ratio. But when I'm comparing funds on Vanguard and Fidelity, I notice that many funds with low expense ratios (<0.04%) have very similar annual returns. A lot of discussion has been focused on the importance of a low expense ratio, but is that the only most important factor we think about when choosing funds? Should I also consider other factors like return? But when I look at multi-year returns, these numbers are so close that I'm not sure how to choose. I am curious about any suggestions from this community.

Let's say risk is another factor. But I'm relatively young so I'm ready to take (maximize) risks. I still end up with a large number of funds with similar returns.

Background: US-based, turning 30, employed, ~40K investment

Thank you

[ertyu]

Try bogleheads.org as well - it seems to me they are the people who will be able to advise you best.

[xmj]

But when I look at multi-year returns, these numbers are so close that I'm not sure how to choose. I am curious about any suggestions from this community.

Take a look at the funds' biggest components and you'll see it will be the same tech stocks with similar weights.

This doesn't mean you should discard them. Pay the least for market exposure (called "beta" by some) that you can, but do get yourself some market exposure all the same.

What you might look into is what other "factors" exist. Factor investing is a thing and investing into large-caps (what most index fund investing boils down to) is but one strategy.

[2Birds1Stone]

If you're comparing 10 different SP500 index funds, they will all have nearly identical returns, ditto for funds/ETF's that track other index's.

You biggest decision is probably more around what you want your asset allocation/investment portfolio to look like at a macro level. This will be based on several factors including risk tolerance, investment time horizon, desired/necessary rate of return, geographical implications, tax efficiency (account types ex. tax deferred/taxable) etc.

Do remember when looking at returns, even over reasonably long periods of time, things that do well in one market cycle may do poorly in different market cycles.

[Western Red Cedar]

You can check out Portfolio Charts for a good introduction on different portfolios, asset allocation, and the underlying philosophy. It was developed by an ERE forum member:

https://portfoliocharts.com/portfolios/

I think understanding your own psychology, fears, and appetite for risk is one of the most factors when choosing funds and an asset allocation. You can read Morgan Housel's "Psychology of Money" for more on that topic. It pairs well with JL Collins writing on investing.

[thef0x]

Everyone's comments are spot on re picking which fund vs picking your general portfolio allocation, so to add something new:

One cool thing these virtually identical indexes enable is tax loss harvesting your losses while maintaining the same underlying portfolio of assets.

Let's say you lose $5000 on the S&P500 ($VOO) on your most recent principle investment. You can sell your $VOO, realizing the loss against income, and then buy a nearly identical index fund, $SWPPX. You've effectively reduced your taxable income (not taxes, taxable income) by $5000 while continuing to own the same underlying bucket of equities. Many "roboadvisors" do this work for you but it's quite simple to do yourself. If you really hate owning $SWPPX, wait 31 days to ensure your repurchasing is not considered a wash-sale, then buy back into $VOO.

This is one way to beat the average investor <-- tax optimization.

https://corporate.vanguard.com/content/ ... online.pdf

[conwy]

Background: US-based, turning 30, employed, ~40K investment

Nice work!

Keep it up though – I would recommend aiming for $500k-$1M.

One thing that I'm convinced of is that I should be investing in index funds and should be looking for a low expense ratio. But when I'm comparing funds on Vanguard and Fidelity, I notice that many funds with low expense ratios (<0.04%) have very similar annual returns. A lot of discussion has been focused on the importance of a low expense ratio, but is that the only most important factor we think about when choosing funds? Should I also consider other factors like return? But when I look at multi-year returns, these numbers are so close that I'm not sure how to choose. I am curious about any suggestions from this community.

IMO expense ratios are not the only or even main factor to consider, they're just one aspect.

The first thing is to work out your goal. Do you want to retire early with a modest lifestyle to pursue your (mainly non-financial) interests?

Based on your goal, you can then engineer a solution that is most likely to succeed. Most likely means, e.g., 85% or higher probability of success. (Nothing in life is totally risk-free.)

Empirically and theoretically, the best strategy that has worked under the greatest variety of conditions over recorded history is low-cost index fund investing. Simply buying and holding the whole market (or as much as you can in cap weights) allows you to capture the returns of the market. Market returns have beaten inflation by 2-6% over recorded history.

Any deviation from the market portfolio means that there is some sector, category, methodology, etc. which you think will offer superior returns to the market. So far, practically no other strategy has been discovered that will consistently succeed (there is new research into "factors" but more on that later).

Index funds win both empirically and theoretically. Empirically: historical data going back 200+ years, based on data-sets such as DMS, demonstrate solid market returns. Theoretically: multiple theoretical frameworks including "efficient market" hypothesis and "behavioural finance" converge on this.

Fees are important because a big aspect of the inflation-beating property of stocks is the compounding of returns, which is heavily affected by small percentage changes in returns such as fees. Mathematically, compounding works as an exponential function, which means even a seemingly small change in an initial value can generate a massive change in the resultant curve. This principle is expounded in the "rice/wheat and chessboard problem", a famous riddle that dates back to ancient times. https://en.wikipedia.org/wiki/Wheat_and ... rd_problem. So even a 0.5% higher fee can have a big negative impact on your future returns if it is not compensated by equivalent gains. As mentioned earlier, there are almost no methods of investing that offer higher returns than the market, so any fees above the minimum are usually unlikely to be compensated.

Exception to the above rule:

Now it is possible to earn a very very small premium (I believe in the vicinity of 1-2% higher) by investing in a manner in which you are always buying stocks which the market systematically undervalues. This means stocks which are always cheaper and always offer a higher expected return for a reason which is demonstrated to be persistent and not related to pricing at just one point in time or one market cycle etc. (Basically cheaper for a reason which is unlikely to change tomorrow, next year, next decade or next half-century).

A tiny handful of strategies have been discovered through rigorous research and modelling, known as the "Fama French Five Factors". Of the 5 factors, the most accessible to retail investors like us is small-cap value. Small, profitable and cheap companies tend to deliver a small premium over the market and this is demonstrated pretty much in the whole historical record.

Theoretically, there is some debate over why this is the case, but there seems to be a consensus that it's because they're "riskier" (finance-speak for more volatile). So you are "earning" the premium of small value because you are taking more risk, which is the same principle index funds rely on. You can access small cap value through ETFs from Dimensional Fund Advisors and Avantis among a few others, with minimal fees (relative to the product you're getting).

Some videos on this:
- https://www.youtube.com/watch?v=2MVSsVi1_e4
- https://www.youtube.com/watch?v=dSyB5CjALYk

Now whether you want to take more risk to get higher return via small value is up to you.

The approach I think about is utility-based. I divide my investments into two categories:
1. High utility + Low risk: One to cover basic essentials like food and clothing, maybe shelter
2. Low utility + High risk: One to cover nicer stuff like an occasional restaurant trip, air conditioning, etc

I would use a safer portfolio (e.g. index funds, TIPS) to cover the essentials (1), which will be more reliable and less volatile.
I would use a "riskier" portfolio (e.g. small-cap value) to cover nicer stuff (2), for which you are Ok with the risk of going without.

If you live by the ERE philosophy, you can reduce (1) by a great degree.

Sorry if this was a bit of an essay, I hope it helps. All the best with pursuing your dreams!

[GreenMonsta]

As you have observed, most of the broad market index funds have similar expense ratios and similar returns. I once worried about the “perfect” or “right” investment strategy. S&P 500 or total market? Value or growth? Should I own small caps? Does it make sense to own international funds? Emerging markets? Are bonds too conservative? Etc.

At some point in the confusion I stumbled upon the realization that a reasonable return coupled with a very high savings rate was sufficient to achieve my goals. Along those same lines, with a high enough savings rate, one doesn’t need to tolerate “maximal risk”. However, at the other end, those with rather low savings rates are compelled to invest in lottery tickets.

Not that I do it, but VT and chill makes a lot of sense for someone wanting to own equities but unsure how to divvy up.