When investing, the fees matter as much as the returns

Investment fees, even those that seem relatively low, have a way of taking a bite out of your long-term gains. The reason? Compounding. For example, a yearly fee of 1.5% on a $25,000 investment earning 7% will net out to $163,000 in 35 years. Drop that fee to .5% a year and your take is $227,000.
While clearly, driving down fees will have a huge impact on any portfolio you plan to hold long-term, doing so can be difficult, especially if your portfolio is made up of mutual funds, whose fees typically range from 1 to 2%.
Because some of those fees pay for managers to buy and sell strategically, one way to drive down fees is to focus on index investing. For example, The Investment Company Institute reports that average cost of an index-tracking mutual fund is .74%. Compare this to the 1.22% Morningstar reports as the average annual fee charged by the more than 1,500 large cap funds it and the savings are clear.  
As it turns out, indexing may not just offer savings; it may actually give you better returns. Indexing as a form of passive investment has been championed by the likes of Warren Buffet, John Bogle (founder of Vanguard), and David Swensen (Chief Financial Officer of the Yale Endowment Fund)1. More importantly, the research also supports pursuing passive strategies. The SPIVA scorecard, an effort by the S&P Dow Jones Indices, measures the performance of actively managed funds against their relevant indices. Its results suggest actively managed funds frequently fail to deliver – over any time horizon.
“During the one-year period, 84.62% of large-cap managers, 87.89% of mid-cap managers, and 88.77% of small-cap managers underperformed the S&P 500, the S&P MidCap 400®, and the S&P SmallCap 600®, respectively. The figures are equally unfavorable when viewed over longer-term investment horizons. Over the five-year period, 91.91% of large-cap managers, 87.87% of mid-cap managers, and 97.58% of small-cap managers lagged their respective benchmarks. Similarly, over the 10-year investment horizon, 85.36% of large-cap managers, 91.27% of mid-cap managers, and 90.75% of small-cap managers failed to outperform on a relative basis.”2
Once you decide to make the switch to index funds (or even if you don’t) there’s another step you can take to drive down fees: replace your mutual funds with exchange-traded funds (ETFs). ETFs, the mutual fund’s more tax-efficient and user-friendly cousin, charge a single transparent fee that is often less than half that of a similar mutual funds. For example, in a comparison among three S&P 500 based index funds that strive to mimic the broad S&P 500 Index, the Vanguard S&P 500 Growth Index Fund ETF Shares (VOOG), USAA S&P 500 Index Fund Member Shares (USSPX), and Great West S&P 500® Index Fund Initial Class (MXVIX), we see a $7,000 spread in the final earnings on a $100,000 investment over a ten-year holding period, even though the estimated return, 5%, was the same in each case (see Table 1).
Table 1

  VOOG USSPX MXVIX
Fund type ETF Mutual Fund Mutual Fund
Estimated return 5% 5% 5%
Operating expense .15% .26% .60%
Fees after 10 years $1917.99 $3,304.68 $7488.27
Total profit $60,464.51 $58,709.18 $53,404.60
 
With such a strong case for using index-tracking ETFs, it might be tempting to dive right in. Just pick an index fund that matches your risk tolerance, sit tight and watch your portfolio grow, right? Not so fast. There are many more variables to manage in a successful index investment strategy than simply measuring risk tolerance and buying the corresponding ETFs.  Utilizing ETFs in a way that fits your overall portfolio objectives is also important. As J.J. Zhang of MarketWatch noted, index funds are “…not a panacea or an excuse for ignoring investing fundamentals.”3 When in doubt, talk to your advisor before embarking on a new investment strategy.

Citations:
1. David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment (New York: Free Press, 2005)
2. SPIVA® U.S. Scorecard, mid-2016.
https://us.spindices.com/documents/spiva/spiva-us-mid-year-2016.pdf
3. http://www.marketwatch.com/story/the-downsides-to-indexed-investing-2013-06-19