I was shockingly surprised to know how many people understand that knowledge is power in investing world. Recently I was talking a friend about his investing style. He proudly explained to me that he only invests in mutual funds or ETFs. His methodology to choose funds is way simpler. He looks up the top performing funds on morningstar and then invest in few of them. He also moves funds from non performant funds to new funds chosen at the end of the year.
Upon more discussion, he mentioned that all of his portfolio is in actively managed mutual funds which offer far superior gains than passive index funds.
This was opposite of what you usually hear but to continue discussion, I asked him what about expense ratio (aka fund’s operation fees). His response, “cost is very little compared to the returns you make in a good year”.
He further mentioned, that last year in 2019, he made about 25% returns from his actively managed fund. On further investigation, I found his fund charged him close to 0.46% in operational fees which was peanuts compared to returns he made, right?
It was good to know that he was aware of expense ratio which most investors aren’t. For those who are unaware of what an expense ratio or operation fees are, here’s a short definition:
What is Mutual Funds Expense Ratio?
The expense ratio or manager’s fee or operational fee are same thing. When you invest into a mutual fund or ETF, the money goes to a fund manager. The job of a mutual fund manager is to find investment opportunities to outperform average market returns.
For managing and investing your money, you as an investor pays a fee to mutual fund manager to cover his/her business operational expenses.
The mutual fund or ETF’s expense ratio is charged at certain percentage of a portfolio’s size. For instance if expense ratio is 2% and your portfolio is about $100,000. You will end up paying a fee of $2,000 at the end of the year. As your portfolio increases or decreases, the fee will change as well.
My friend here knew that expense ratio is a cost he needs to bear but how much is too much over a period, is something most of people don’t realize, including my friend.
I tried to talk him out of active funds favoritism, but in the end, I could see that my arguments made no difference to his investment philosophy as he was happy with the returns his fund manager generated for him last year.
By the way, in 2019 overall market did very well. For instance S&P 500 gained close to 30% in 2019. So comparatively my friend’s actively managed Vanguard Explorer Fund Investor Class fund did poorly.
I thought, it will be better if I talk to my readers and explain to them how dangerous active mutual fund investments could be over a long period of time even if the manager fee seems small.
Lets get started with our analysis of some of the top active and passive mutual funds or ETFs.
What are Actively Managed Mutual Funds?
Before we dive into our analysis, for the sake of new comers, it’s my duty to explain the what are actively managed funds.
An actively managed fund is like a regular mutual fund or ETF except that the money is invested based on decisions made by fund’s manager and his/her team.
They might see an opportunity and move the funds into it. The opportunity may or may not be fruitful, but what is consistent within actively managed funds is that shifting of money takes place more often than non active funds.
The shifting of money from one investment to another also incur other costs such as tax on gain in previous investment, brokerage fee, etc. Adding these additional tax and fees, reduces overall fund’s returns.
What are Passively Managed Mutual Funds?
A passively managed fund is opposite of actively managed fund. In this, the fund manager or his/her team can’t make decisions where the money will be invested.
So, why do we need fund manager and his/her team then?
Well, we need them to track the index fund configuration and adjust the mutual fund’s portfolio accordingly. In other words, in passively managed funds, manager’s job is to track some benchmark such as S&P 500 index and buy companies in the same proportion as in S&P 500 index.
In this case, the money doesn’t shift too often between one investment to another. A fund manager only needs to trade when a company is removed from an index and so he/she has to remove it as well from their portfolio.
The reduction in number of transactions, lead to reduction in tax payout, brokerage fee, etc. So, the overall returns are superior to actively managed funds.
My Analysis: Vanguard Explorer Fund Investor Class (actively managed fund)
Now it’s time to analyze Vanguard Explorer Fund Investor Class or VEXPX fund which my friend had invested in few years ago. Since he didn’t exactly tell me when he started his investment into this fund and also I am not trying to analyze his investment in particular, so I will analyze the fund from the day the data is available on Yahoo Finance until 2019.
So, lets get started.
I have used monthly average close price for VEXPX since 1980 until 2019. To keep this simple, I will use January of each year since 1980 to get the start price of the fund until following year.
This is how it looks in my spreadsheet for one time $10,000 investment:
For each of the year, I have the average price in month of January. The year on year return indicates how much price per unit change between current and next year. For instance in 1980, the price of VEXPX gone up by 34.37%.
Next column shows dividend earned per unit of VEXPX in the year. This is the total dividend for entire year. If you had re-invested the dividend (which is the best way to use dividend), few extra units will be added to your portfolio as shown in next 2 columns – dividend reinvested units and total units.
Finally what a common investor is most interested to know is his/her portfolio size at the end of the year. The Portfolio (before fee) shows total value of your portfolio before any management fee is taken out.
Next is the expense ratio, aka operations fee for hiring fund manager to invest your money. For Vanguard Explorer Fund Investor Class, expense ratio is 0.46 which is lower than industry average for actively managed funds.
Portfolio (after fee) indicates the value of your fund after the manager’s fee is deducted and finally last column shows the money paid per year to manager for his/her services. You might think why do I care about $62.61 a year in fees to someone who is working day and night to earn me more money? If that’s your thoughts, then hold your thoughts and wait for few more minutes.
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How much did you make in VEXPX
I know you are wondering how much you end up in 2019 after 40 years of investing in VEXPX. So, here it is:
You will end up turning initial $10,000 invested in VEXPX on January 1980 into $339,696 by 2019. This translates into a CAGR of 9%.
This is a great return for $15,948 in management fees over 40 years. The management fee, although charged at 0.46% per year, but in the end the cumulative effect is about 4.7% of the net portfolio in 2019 or 160% of initial capital invested. Is it worth to pay 4.7% for a 9% return? Hold on your thoughts for a moment.
Next look at a passively managed mutual fund.
My Analysis: Vanguard 500 Index Fund Investor fund (passively managed fund)
After looking at an actively managed fund which did very well in last 40 odd years, it was time to analyze a passively managed fund.
I wanted to know if it’s true that active managed funds will underperform passively managed funds over a long period of time.
These 2 funds chosen are one of the top funds in their categories so, I am intentionally biased towards funds which performed well in past.
For passive fund, I chose VFINX which is one of the most famous vanguard fund out there.
I will not bore you again with spreadsheet details, so here’s how your portfolio will look like in the end of 2019 when $10,000 were invested in VFINX on January 1980.
I have hide some years from above screenshot to fit it into one snapshot.
With VFINX you will turn $10,000 invested in VFINX on January 1980, into $575,792 (after manager fees). That translates into a CAGR of 10% on management expense ratio of 0.14%.
Do you think VFINX is worth paying $8,432 ( net 1.5% of final portfolio or 80% of initial investment of $10,000 ) in management fee for a return of 10% over a period of 40 long years? My first response is ‘Hell Yah‘.
Is it worth to invest in actively managed funds?
As my friend might have earned over 9% on average returns on his investment in VEXPX fund, someone will earn 10% average returns for half the fees in same time.
Even though both the funds are from same Vanguard group, and there’s a mere difference of 1% in their average returns over 40 year period, the final portfolios differs by $236K. Read it again.
I will add another parameter to our analysis which most people ignore – ‘opportunity cost’. An opportunity cost is loss of potential gains you could achieve but couldn’t due to alternative investments you made.
In our examples, we paid annual management fee of 0.46% and 0.14% in these 2 funds. If those fees, were reinvested yearly into same funds like dividend is reinvested, then it would have increased our returns even further.
The last 2 columns in below screenshot shows the loss of potential gains aka opportunity cost for respective funds.
As seen, over long period of time, a minor fee paid turns into a major opportunity cost. The difference between both the funds is almost double in terms of opportunity cost.
What does it mean – No Mutual funds?
I am not trying to prefer one investment over other in this post. The goal here is to understand that knowledge is power in investing world. Most common investors do not go this far while planning their retirement investments.
Read more: Best Retirement Planning
What I want you and I to understand here is that there’s a huge hidden cost to whatever investment you choose in the world of mutual funds and ETFs. If the fund is actively managed, the cost will a way higher for subdued returns.
As we saw in above example, VFINX which closely tracks S&P 500 index outperformed VEXPX fund. S&P 500 is an average weighted return of 500 top companies in US.
What is the point of hiring someone and paying them extra to not even beat the average market returns?
Even if someone manages to outperform index over a period of time, it will be impossible to do it consistently forever. In fact, 90% of funds underperform S&P 500 over a period of 10 years, 95% underperform over 20 years period and 99% underperform in 30 years period.
So, what should we do about it? Since the chances for a common investor to even beat active funds are zero to none, do we got any other option?
Why do we invest in Mutual Funds or ETFs
First question you want to ask yourself, is why do you want to invest in Mutual funds?
If you are not among 1% of the top investors like Warren Buffett, Peter Lynch, John Templeton, etc; then you can’t beat the market. Period.
It’s fools game to even try it and the results could be devastating.
So, we have only one option to grow our portfolios, which is through investing in mutual funds. Unfortunately, the markets are not for common investors anymore and it’s nearly impossible to beat it.
But there are few logical things we can keep in mind which are very uncommon these days:
- when you pay manager fee, you are NOT buying more RISK in return.
- Portfolio manager’s job should be to lower the risk and grow at average or above average returns without taking too much of risk.
- Your ultimate goal should be to preserve the principle and earn decent returns over a long period of time – don’t shoot for the stars. The fall is deadly.
Even after earning 3 times more in fees, VEXPX managers underperformed VFINX over 40 year period. Was this fund worth your money?
Always keep risk to reward in mind. How confident are you on your fund manager, knowing that only 1% of them can beat the market consistently?
If you are not confident, then what are you paying extra for? I am sure not to earn less than the average investor out there.
What Mr. Warren Buffett know about Index Funds
In his 2013 letter to shareholders, Warren Buffett said:
My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.-Warren Buffet’s 2013 Letter to Shareholders (emphasis is mine)
Why Warren Buffett suggested to invest 90% of his wealth into very low cost index funds? Could you not hire the best of the best fund managers to handle his portfolio after he is gone and continue to beat the market like he did for so long?
The answer is simple. He knows the truth that it’s not possible to beat the average returns of market over a long period of time even for himself.
In recent years, his company Berkshire Hathaway; managed by Warren Buffett himself, underperformed the S&P 500. Here’s the proof:
Having said that, I stand no way near Mr. Buffett. His knowledge is enormously vast and that’s why he has been a consistent market beater over last 40+ years. The only point I am trying to make here is, it’s very very difficult to consistently beat the market over a long period of time. Even for great investors like Warren himself.
Do you believe that Knowledge is power in investing world?
I strongly feel that you will agree with me that knowledge is power in investing world now. But it’s not about what you know rather on what you do with that knowledge.
I have seen people, who can be called idealistic thinkers but when it comes to their actions, they are far from idealistic. The prime reason of this behavior is that there’s a huge difference between saying and doing.
All of us including you and me, need to decide whether we are ‘sayers’ or ‘doers’. Eventually our future will depend upon what we did with the knowledge we gained throughout our lives.
I would love to hear your thoughts or experiences in this regard. If you had been an investor, comment below and share your story with all of us.
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