Hidden Cost of Index Funds -A Close Look at Fees

My goal this year has been to gain a better understanding on investing. We’ve been following Dave Ramsey’s advice for years but we haven’t dug deep into analyzing how we’ve been investing and the returns we’ve gotten. Now that we’re learning about personal finance through other sources, I’ve come across many conflicting investment strategies. Which is right? In this post, my husband crunches some numbers to compare managed mutual funds to index mutual funds.

Hi, I’m Mike. I am grateful that my wife has let me take up space on her blog to write this. For those of you who follow this blog, you are now well aware of our decision to make the journey towards financial independence. We started down that path with Dave Ramsey’s Financial Peace and, more recently, we have discovered the FIRE (Financial Independence/Retire Early) community.

When we started with Dave Ramsey, I was the reluctant partner who was too macho to admit my financial literacy shortcomings. I eventually came around and together we found financial success by living debt free and guided by our budget-restrained goals. We still need to work for income however, we can see a comfortable retirement on the horizon and, even early retirement with travel and other shared goals for our family. I thought we were doing pretty well until my wife recently came to me, somewhat concerned, after listening to a FI-related podcast.

The podcast (Choose FI) was discussing the difference between index funds with ultra-low gross expense ratios (.05% or so) and, managed funds with gross expense ratios that can vary between .5% – 1.5%. The main premise seemed to be that managed funds will end up reducing your retirement savings by nearly 50%! I could completely understand why my wife was concerned. I was nearing panic.

Am I Losing My Retirement Due to Mutual Fund Fees?

Now, for the bulk of our retirement savings strategy, we have been following Dave Ramsey’s advice of diversifying across four different types mutual fund families that have long term track records of 10%-12% growth since inception. There were some years early on when we were not fully invested and, lost out on some of that growth but, for the most part our mutual funds have been returning that 10%-12% range. I have felt pretty good about what we have been doing. When my wife pointed out that the expense ratios on our funds were astronomical compared to the index funds we were hearing about in the FI community, I grew concerned and wanted to learn more. She shared the podcast with me (Choose FI 003 Let’s Talk About Fees | Why Investment Fees Are Evil and How to Avoid Them) and I listened intently to figure out what we were doing wrong.

The podcast team posited a hypothetical situation to show how an investment over 40 years would grow and, what effect fees would have on an individual portfolio. They used the Dave Ramsey Investment Calculator tool (one I use on a regular basis) to help them demonstrate the math. Over the course of the example, I followed along so that I could see what they were doing and then applied it to our funds to determine how much we were going to lose. Boy were we in for a tremendous surprise!

With that, I want to share with you the steps I followed, with screen shots to make it easy for you to follow along.

So, the hypothetical situation set forth on the podcast was $100,000.00 invested for 40 years with no additional money added over the life of the investment with a stock market return of 8% (based upon a “reasonable” estimate according to our hosts).

Scenario One – Index Fund

Invest $100K in VTSAX with a gross expense ratio of .05% (ultra-low) yields a return of 7.95% (8% return – .05% Gross Expense Ratio). This would equate to $2,132,582.00 (figure 1). This is great! Over 2 Million dollars to use through retirement.

Figure 1 – Index Fund VTSAX with 8% return over 40 years with $100,000 initial investment.

Looking at the performance of VTSAX, the average annual return of that fund before taxes and fees has been 6% (Figure 2), not 8% so, assuming we take the longer track record of VTSAX, that would be a return of 5.95% using the method set forth in the podcast (Figure 3). This lowers the amount to $1,009,342.00.

Figure 2 – Index Fund VTSAX average return since inception.

Figure 3 – $100,000 initial investment in Index Fund VTSAX’s over 40 years but reflecting it’s average return since inception of 6%.

So we can see that investing in an index fund can, indeed, make for a comfortable retirement with little to no fees. Having $1M to live off in retirement is not bad at all. Let’s move on to scenario two:

Scenario Two – Index Fund Plus Advisor

In scenario two, the hosts of the podcast discuss hiring an investment advisor who charges a fee of 1% to do the investing for us while still using VTSAX. Going back to the original scenario with an 8% annualized return, we would now get 8% minus the 1% investment fee and minus the .05% gross expense ratio for an annualized return of 6.95%.

Figure 4 – $100,000 initial investment over 40 years in Index Fund VTSAX plus advisor fee.

As the hosts correctly point out, this is over $600,000.00 lost due to fees! Yikes! I know that if I paid an investment advisor any amount of money, I would want to make sure they are picking funds that would be performing better than that! Let’s move on to Scenario Three.

Scenario 3 – Managed Fund Plus Advisor

In scenario three or, the worst-case scenario, the hosts lay out the scene where the hired investment advisor (at a 1% fee) puts our money into a mutual fund that has a gross expense ratio of 1%. This would take our initial return from 8% down to 6% (8% minus 1% advisor fee minus 1% gross expense ratio).

Figure 5 – $100,000 initial investment over 40 years in managed fund plus advisor fee.

This takes our initial scenario and does, indeed, cut our potential growth by over 50%!!! Ok…now I am really worried.

Gross Expense Ratios – Friend or Foe?

So, let’s take this same approach and use some funds that have a higher expense ratio but, are simply bought through a brokerage account without any help from an investment advisor. This is the method my wife and I have been using for our retirement. Will the math show that I will need to work for another 40 years? Will the “evil” fund managers and investment advisors steal over 50% of our retirement? Let’s find out.

To begin, I did a mutual fund screen on Charles Schwab (can be done on any brokerage firm’s site) to find mutual funds in the Large Cap family with an inception date close to that of VTSAX. I also wanted an average annual return since inception of greater than 10%. This yielded a result of about 10 different funds between 1998 and 2003. I chose four that were the closest in the time frame for apples to apples comparison.

Figure 6 – Gross expense ratios of 4 managed funds compared to index fund VTSAX. All with similar inception dates.

As you can see, the gross expense ratios are massively high compared to VTSAX. Using the approach that was laid out in the podcast, let’s crunch some numbers.

First, we know from earlier that over 40 years, VTSAX returned 6% (not 8%) since inception. Using that return, we saw from the calculator that we were able to achieve $1,009,032.00 in retirement.

Figure 7 – $100,000 initial investment over 40 years with index fund VTSAX with 6% average return since inception.

Now let’s look at the returns of other funds with higher expense ratios and see what we are losing. As we can see, the funds below have significantly higher returns. Let’s take the same approach to understanding how much we will earn in retirement using these funds. To quote the Schwab page for the Monthly Pre-Tax Footnote 1: “Time periods of less than 1 year are actual returns and time periods of greater than 1 year are average annual returns.” For everyone reading, we do not hold any of these funds at the time of publication nor do we recommend these or any other funds discussed.

Figure 8 – Comparing the returns of 4 managed funds and index fund VTSAX.

Let’s take the first fund listed – SGRKX – and put it through the same 40 year calculation:

$100,000.00 invested over 40 years with nothing added. The average annual return since inception is 11.58% minus the gross expense ratio of 1.10%. This, using the math set forth in the podcast, would amount to an average annual return of 10.48%. What does that equal? $5,386,995.00.

Let me type that again – $5,386,995.00! That is 4 MILLION DOLLARS MORE than the same amount invested in an index fund over the same amount of time. Are we losing money due to gross expense ratios? No, it appears that we lose more money with funds that have ultra-low expense ratios – we lose $4 Milllion to be exact!

Figure 9 – $100,000 initial investment in managed fund over 40 years.

So, how much did we pay the fund managers? Who cares! They made us $4 Million Dollars Richer!! Truth being told, the fund managers will make over $2 Million in fees in the fund with the high expense ratio versus the fund manager making approximately $8,000 from the index fund. This was figured out using the calculator here: https://www.bankrate.com/calculators/retirement/mutual-funds-fees-calculator.aspx. I don’t know about you but, I would rather have $5.3Million in retirement than $1.01M.

Finding High Performing Mutual Funds

Ok but, how many funds are out there that really can beat the market? After all, one of the premises of the podcast/FI Community is that no one can make those types of returns over a prolonged period of time and, that investing in companies is akin to going Vegas and putting your retirement savings on red at the Roulette table. So, let’s take our screen and broaden our horizon to look for mutual funds that have been around for three or more decades. This particular screen gave us 50 different funds to chose from.

Figure 10 – Finding high performing mutual funds.

Figure 11 – Gross expense ratios of 4 managed funds with inception dates from different decades compared to index fund VTSAX.

In the figure above, I have chosen funds that have been around since the 30s, the 40s, the 50s, the 70s, and VTSAX. The 70s were a time of energy and international crises and led into the 80s, 90s, and this millennium which all have seen violent swings in the market. That said, let’s start with TWCGX for a comparison as it was conceived at the beginning of a period leading into market turmoil relevant to this generation.

Figure 12 – The four managed funds returns since inception compared to index fund VTSAX.

TWCGX has a gross expense ratio of .98%. Since its inception nearly 50 years ago, the average annual return has been 12.25%. So let’s plug those numbers into the Dave Ramsey calculator:

$100,000.00
40 years
11.27% Average Annual Return (12.25% minus .98%)
Total: $7,163,471.00

Figure 13 – $100,000 initial investment over 40 years in a managed fund

That is 6 MILLION DOLLARS MORE than a highly touted index fund. That is a significant amount.

Worth the Fees

Now, I honestly did not write this post to pick on anyone who invests in index funds. I truly wanted to find out if our nest egg was in danger of being eaten by fees. After doing the math that this podcast demonstrated, I cannot help but feel that they are doing a disservice to many. The Choose FI podcast even resorted to name calling regarding people who invested in funds that had high expense ratios or, put their clients into those funds.

There are so many people, as they correctly point out, that have been ill-equipped by our public education system to figure this out. As such, many people do not want to invest the time to understand this. That is ok. Financial advisors provide that service. As we can see from the examples above, even if they charge you 1% to help you pick your mutual funds, you can outperform index funds and wind up with MORE money – much more- than you would by simply investing in an index fund with low expense ratios.

A final note:

This post was inspired by a community that is trying to become financially independent and take charge of their own destinies. I highly agree with that. There are many approaches to investing that provide a different comfort level for people with varying risk tolerance. Neither of the approaches above are right or wrong. Both approaches lay out a path to wealth and a comfortable retirement without relying on a government check. That alone is a worthy goal.

My wife and I are always learning and looking for new information to help us in this journey. I cordially invite anyone who can show me a different method of performing these calculations that truthfully shows mutual funds with higher expense ratios or fees are a bad deal or, won’t truly yield the results presented in this post. If you can, please let me know so I can do further research. If validated, I am more than happy to share those findings, with proper credit given, as a future post on this blog (with my wife’s permission of course).