One of the big sales points for index funds and etfs (exchange traded funds) is that they have low expense ratios (ie they cost less) compared to actively managed funds and therefore will perform better (at least that’s the theory). This is a very important concept for passive or index investing but it’s important to understand that not all index funds and etfs are cut from the same cloth when it comes to fees.
Some index funds and ETFs have high costs
In theory, index funds and ETFs should have lower costs than actively managed funds because you don’t have to pay for any high price help to pick the stocks – just select an index to base the investment on and then a monkey can run the fund. In reality however, the owners of an index fund can charge whatever they want. If one of your investment goals is to keep your costs low then make sure you check the expense ratio of every investment you are considering.
Vanguard has very low expense ratios for their products – however they also have minimum investment amounts which make it hard for a small investor to buy them.
Here are some different index funds based on the S&P 500 stock index and the expense ratio:
- IShares S&P 500 Index Fund (IVV) – 0.09%
- E-Trade S&P 500 Index Fund – 0.13%
- Vanguard 500 Index Fund – 0.15%
And here are some not so cheap S&P 500 funds:
- Rydex S&P 500 – 2.25%
- State Farm S&P 500 Index Fund – 1.49%
As you can see there is a huge range of fees for exactly the same product.
What does a couple of percent matter?
A difference of 1% or 2% per year might not seem that significant but over time it can add up. If we compare the Vanguard 500 fund (expense ratio of 0.15%) to the Rydex fund (2.25%) and we assume that the performance of the funds before costs is equal then we might get the following example.
Joe invest $25,000 in the high priced Rydex fund, Sue invests $25,000 in the cheaper Vanguard fund. If we assume that the underlying index returns 7% per year then how much will each investor have after 25 years?
Joe will have$79,761 and Sue will have $131,009! Yes, Sue will have 64% more money than Joe after 25 years which is a rather large amount considering they invested in the same type of investment with the same amount of risk.
How to find out the costs of index funds, mutual funds and etfs
There are plenty of good sources for this information but I use Morningstar which is one of the leaders in financial information. You can sign up for a free membership at Morningstar here or click on the banner below.