Are Some Index Funds Ripping You Off?
High fees hurt returns.
Index funds are often touted as great investment vehicles for their tax efficiency and low fees. Even Benjamin Graham, the founder of value investing, or trying to pick underpriced securities, thought indexing, or just passively tracking the market, was a reasonable idea for most investors, although this didn't mean he thought the market was efficient. Graham knew most actively managed mutual funds weren't able to overcome their fees and beat the index.
Most investors assume, however, that indexing automatically means getting a cheap fund and certainly one that's cheaper than an actively managed fund. However, this isn't necessarily the case. Just as with buying actively managed funds, indexers need to shop around, because fees vary fairly widely.
We recently screened for funds that tracked the S&P 500 Index in Morningstar's database and were especially impressed with the disparity in fees among funds that track the S&P 500 Index. We came up with 85 funds and found that their average net expense ratio with fee waivers was around 0.40% or 0.41%, depending on whether you use the fund's most recent prospectus or its most recent annual report. (Morningstar.com uses the most recent annual report to list funds' fees.)
The highest priced funds were those that tried to add something extra to traditional index-tracking, such as the Invesco Equally-Weighted S&P 500 (VADAX), but at 1.50%, this seems like a steep fee to equally weight the stocks in the index. Other straight or passive index-trackers, however, charged north of 0.50%, such as BB&T Equity Index (BAEQX), which clocked in with a 1% net expense ratio. The class A shares of BlackRock S&P 500 Index (MDSRX) came in at 0.61%, and Dreyfus S&P 500 Index (PEOPX) charges 0.50%. Even T. Rowe Price Equity Index 500 (PREIX), which comes from a shop with generally low fees on its actively managed funds, was only slightly below the average at 0.35%.
Among the most attractive were Fidelity Spartan 500 Index (FUSEX) at 0.10%, Schwab S&P 500 Index (SWPPX) at 0.09%, and of course Vanguard Institutional Index (VINIX) at 0.05%. (Vanguard's retail shares clocked in at 0.18%.)
It should also be noted that exchange-traded funds offer a low-cost way to gain access to the S&P 500 Index. For example, iShares S&P 500 Index (IVV) has an expense ratio comparable to Schwab's mutual fund at 0.09%.Sampling of S&P 500 Index FundsAnnual Report Net Expense RatioProspectus Net Expense RatioBB&T Equity Index (BAEQX)1.001.00BlackRock S&P 500 Index (MDSRX)0.610.61Dreyfus S&P 500 Index (PEOPX)0.500.50T. Rowe Price Equity Index 500 (PREIX)0.350.30Invesco Equally-Wtd S&P 500 (VADAX)1.501.46Invesco S&P 500 Index (SPIAX)0.590.65Fidelity Spartan 500 Index (FUSEX)0.100.10Schwab S&P 500 Index (SWPPX)0.130.09Vanguard 500 Index (VFINX)0.180.18Vanguard Institutional Index (VINIX)0.050.05iShares S&P 500 Index (IVV)0.090.09
How Do Extra Fees Affect Returns?
So, what does paying, say, an extra 0.30 percentage points in fees really mean in the long run? Plenty. If you invest $5,000 per year for 30 years and earn 9% annually, you wind up with nearly $682,000 at the end. However, if you only earn 8.7% annually, you wind up with a bit less than $645,000 at the end. That's an extra $37,000, or something close to a year's worth of tuition, room, and board at a good private college, that you've paid in fees for the fund charging 0.50% instead of the one charging 0.20%.
What Can You Do to Pay Less?
To avoid giving up that kind of cash, consider whether you really need a broker selling you A shares of an index fund. If you're going to index your money, you may not need a broker or advisor to select funds for you. Maybe the broker or advisor helps talk you off the ledge when things get rough. There isn't any question that an advisor who prevented a client from bailing out of stocks in late 2008 or early 2009 did an exemplary job. Consider, however, if you're an indexer, how much you really use an advisor's advice. You may use an advisor for other financial-planning issues rather than fund selection, so see if you can pay that person for those services only, and take your fund business somewhere else.
Another problem may be that you're stuck or held captive in a 401(k) plan at work with an expensive index fund. There are two basic options here. First, see if your plan allows for some expansion beyond the ordinary list of funds into a brokerage account. In some plans, once you amass a certain amount of assets, you may gain access to a fund complex's brokerage platform, giving you the opportunity to invest in other funds. If you choose this option to find a cheaper index fund, make sure you stay on top of making contributions into the fund. Moving money out of the ordinary 401(k) into the brokerage platform and then into the actual fund you want can be a multistep process.
Second, although this can be dicey for some employees, try to figure out a way to approach the people responsible for administering the 401(k) where you work to see if they are inclined to change the plan. Keep in mind that if they are disinclined to make a switch and you don't have much leverage where you work, it's probably not a wise idea to push too hard. You may have to stick with the expensive index option until you retire or find another job, at which point you can roll the 401(k) over to an IRA at a brokerage or fund company that gives you better options.
John Coumarianos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.