You Are Probably Paying Too Much For Your Mutual Funds

with No Comments

Fund expense ratios continue to go down and get cheaper.

According to the Investment Company Institute, by 2017 the asset-weighted average expense ratio of mutual fund investments had dropped to 0.59% and “equity mutual funds with expense ratios in the lowest quartile held 77 percent of equity mutual funds’ total net assets.” Expense ratios for exchange traded funds are usually even lower than mutual funds.

Morningstar Research Services did a similar study which found that in 2017 “investors paid an average 0.52% expense for funds, as measured by the asset-weighted average expense.” They went on to estimate this one-year decline of 0.04% resulted in a four-billion-dollar savings to investors.

Low fees and expenses is one of the best indicators of future returns. And Vanguard Funds have some of the lowest fees and expenses in the industry.

Fund companies often try to compete with Vanguard by suggesting that the brilliance of their fund managers is responsible for out-performing a particular index.

I’ve written elsewhere about how fund companies can beat an index simply by compromising an index. A fund which is categorized as a U.S. large cap stock fund can include a few mid-cap stocks, or a foreign developed countries stock fund can include several emerging market stocks. This helps them beat their index by being slightly different than their index.

Vanguard has recently adopted an interesting approach to fund analysis. Although there is still some random noise that active managers will try to claim is their skill, the suggestion of Vanguard’s research is that any additional performance of an active manager is likely due to stock selection according to known factors which boost fund returns.

They have also accompanied this research with factor funds which are just companies to overweight specific factors. The idea is that rather than purchasing an actively managed fund with an expense ratio of 1.20%, you would instead build a blended portfolio by investing mostly in a Vanguard index fund with a very low expense ratio and then adding whatever Vanguard factor funds you want in order to imitate the factors of the actively managed fund you are trying to mimic. The Vanguard factor funds have an expense ratio of 0.18% and allow you to turn up or down the volume of how much you want to overweight specific factors. The implied suggestion is that the mix of Vanguard funds may out-perform the actively managed mutual fund at least by the significant difference in expense ratios.

Well-diversified portfolios with tilts according to known factors are easily constructed from funds with very low expense ratios.

Currently, we build portfolios with extremely low expense ratios, potentially saving our clients millions of dollars. Our current all-stock Buy List now has an expense ratio of about 0.17%. Any addition of bonds lowers the expense ratio even further. This represents how we would invest a client who came to use in all cash today.

Most clients do not come to us in all cash. Instead, they transfer their investments in-kind and we assess each holding for whether it should be kept or sold. Because we choose not to sell a few historical funds with higher expense ratios on account of capital gains, many client’s experience a slightly higher expense ratio closer to 0.24%. This is still extremely low for the industry.

Part of the work of our investment committee is to look for funds which offer lower costs or a mix of better factors known to boost returns.

While we build portfolios with average expense ratios of about 0.17% or lower, some of the funds we use have expense ratios of 0.47%. We tolerate these funds only because they offer factors that we believe significantly boost returns. But if we were to find similar funds with lower expense ratios we would replace them.

A good rule of thumb, however, is that you should only consider investing in funds which at a minimum have an expense ratio that is below average. Currently the average asset-weighted expense ratio is somewhere around 0.52%. One of the reports we often show prospective clients is simply a list of the funds they are currently invested in and the expense ratio of each. Funds with an expense ratio higher than 0.52% should probably be replaced, often even if you have to pay some capital gains.

Check your own funds. You are likely paying too much for your mutual funds.

Photo by Danielle MacInnes on Unsplash

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.