With investment costs, less is more. Many investors are getting the message that paying less for mutual funds (or for any investment, really) will put more money in their pockets in the long run.
Last year, investors in the United States paid, on average, the lowest mutual fund fees ever, according to Morningstar.
But investment costs are full of unpleasant surprises, and academic studies have found that many people aren’t taking advantage of better-priced alternatives.
“In one part of the market there is enormous cost competition, and investors there have never had it better: They can buy funds almost for free,” said Micah Hauptman, financial services counsel with the Consumer Federation of America, a nonprofit research and advocacy group.
“But outside of that space, there isn’t as much competition,” he said. “Investors need better information about what they’re paying and what they’re getting.”
By now, many people know that fund fees take a toll on returns.
One well-known calculation from the Department of Labor found that, over 35 years, a difference in fees of 1 percentage point could reduce the final value of a 401(k) account by a harrowing 28 percent.
Now, many investors are voting with their wallets.
As a result, the market share of low-cost passive funds swelled to 32 percent in 2016, from 23 percent in 2012.
On the face of it, there is a benevolent domino effect happening: As more investors choose cheaper funds, the assets in those funds grow — and the corresponding costs further decline. Or they should.
But positive as this trend may be, it masks some glaring, persistent differences in fund costs throughout the industry, said Michael J. Cooper, a professor of finance at the University of Utah. “Expense ratios are dropping, which is wonderful,” he said, “but the disparity between high-cost funds and low-cost funds hasn’t changed.”
Cooper and two colleagues examined the costs of over 20,000 equity mutual funds in operation in the United States between 1966 and 2014.
The study revealed a constant disparity in fund pricing over time — and the risk of lower returns for those who buy pricier funds, because of the compounding effect of fees.
“The costs for getting it wrong — investing in high-expense funds when close-to-identical low-expense funds are available — are large,” the authors write. “We show that a low-expense fund investor could have earned 70 percent to 145 percent more” than someone who chose comparable funds at a higher price.
The authors looked at the effect of fees over a 48-year horizon, which helped to show the potentially dramatic toll of investment costs over decades.
The analysis built on work by other researchers who had found that Standard & Poor’s 500-stock index funds, which merely track the S&P 500, show a surprisingly wide price gap, “despite being basically the same peanut butter,” Cooper said. He found that, from 2000 to 2014, an investor in the lowest-cost S&P 500 index funds would have ended up with a balance 22 percent higher than someone who invested in the highest-cost funds.
“It’s baffling,” said Hauptman of the Consumer Federation of America. “You have nearly identical funds, yet one can cost 1 percent more than the other. In a competitive environment, why do these products exist?”
Yet they do. Even confining one’s view to the landscape of S&P 500 index funds — often referred to as plain vanilla funds because they simply mirror the performance of big companies — the range of choices is dizzying. There are about 50 different S&P 500 funds, with over 150 different share classes, according to Morningstar, and fees vary widely.
The annual expense ratio for the Admiral shares of Vanguard’s 500 Index Fund (VFIAX) is 0.04 percent basis point, compared with 1.55 percent for the A shares of the Rydex S&P 500 Fund (RYSOX), which also charge a sales fee of 4.75 percent.
What can account for such stark differences? One reason Vanguard maintains such low fees is the economy of scale of its equity index funds, which are among the biggest and cheapest in the industry.
“We can keep passing on the economies of scale to the investors, who are basically creating them,” said Joseph Brennan, director of global equity indexing. Vanguard is owned by its mutual fund shareholders, and that unique structure provides an incentive to keep costs low.
Rydex funds have fewer assets under management, which can drive up costs. And the Rydex S&P 500 fund “is more expensive than some other index funds because it is priced twice a day and designed for tactical fund traders,” said Ivy McLemore, a spokesman for Guggenheim Investments, which offers the Rydex funds.
It can be hard to parse various funds and their costs. But the fee-conscious can still take matters into their own hands. The Financial Industry Regulatory Authority offers a fund-analysis tool, as does Feex.com, an online service that can analyze the fees you’re charged.
M.P. Dunleavey writes for the New York Times.