Wednesday, May 1, 2013

Index VS Managed Funds

The effect of expense ratios and sales loads on mutual funds can be enormous. The following example comes from a lurid and sensationalistic piece of agitation propaganda, “PBS Drops another Bombshell: Wall Street is Gobbling up Two Thirds of your 401K.”

Here is the example they give to support their hypothesis.

“Pull up a compounding calculator on line. Take an account with a $100,000 balance and compound it at 7 percent for 50 years. That gives you a return of $ 3,278,041.36. Now change the calculation to a 5 percent return (reduced by the 2 percent annual fee) for the same $100,000 over the same 50 years. That delivers a return of $1,211,938.32. That’s a difference of $2,066,103.04.”

While this example is mathematically accurate, nobody puts $100,000 in an account and then doesn’t touch it for 50 years, but the author does make her point. If you aren’t careful, the Wall Street investment machine will end up keeping way too much of your money.

Let’s return from cloud cuckoo land and compare a few sound realistic investment alternatives. Dave Ramsey teaches his students can reasonably expect a 12.0% return on retail stock mutual funds. While defending this position Dave Ramsey states, “I own a mutual fund with an 11.98% average return since 1934, 13.4% average over the last three years. Is your investment adviser too STUPID to find this?”

In an article entitled “Dave Ramsey: American Funds (AIVSX)” the author identifies the fund in question, American Funds ICA (AIVSX), a sound well managed fund that has in fact been around since 1934 and it has delivered an average return of 12.0% over 78 years.

But let’s dig a little deeper into those numbers and compare them to a low cost index fund and a low cost managed fund that is directly comparable to AIVSX. First of all while 13.4% over the last three years sounds pretty outstanding, the return for the S&P 500 during the same three year period was 16.6%. The poster child for retail managed funds sold by commission salesmen didn’t beat the S&P.

Three years isn’t a very long time horizon. Seventy eight years is of no interest to me. The managers that founded the fund are pushing up daisies in the Eternal Rest Memorial Gardens, as their great grandchildren are pulling the trigger on today’s trades.

First let’s look at the effect of expenses on a hypothetical $50,000 investment for 20 years. American Funds AIVSX carries a 5.75% sales load and an annual expense ratio of 0.62%. Compare this to two offerings from Vanguard. First the Vanguard 500 Index Fund (VFIAX), a low cost index fund with no sales load and an annual expense ratio of 0.05%; then the Vanguard Growth and Income Fund (VGIAX), like the American Funds offering, an actively managed fund. However, VGIAX carries no sales load and an expense ratio of 0.25%.

Here are the results after 20 years at an average 9.0% return:

$233,218 American Funds AIVSX
$277,432 Vanguard 500 Index Fund
$266,537 Vanguard Growth and Income

And the winner is---the low cost index fund. By the way, $16,597 of that $44,214 difference was savings on loads and fees.

In that example we assumed the three funds all would produce the same return on your investment. Let’s take a look at what really happened over the last ten years.

7.44% American Funds AIVSX
8.52% Vanguard 500 Index Fund
8.03% Vanguard Growth and Income

Once again the low cost index fund is the clear winner. This is not an anomaly. The most recent numbers I can find indicate that 0.4% of managed funds outperform the S&P 500 over the last 10 years. There are approximately 18,000 mutual funds out there. Do you think you are lucky enough to pick one of the 72 winners? The odds of picking the winner of next year’s Superbowl out of a hat are much better, 1/32 or 3.125%. There are reams of academic studies that support the position that low cost index funds are your best bet.

Here is a recent study from Morningstar:

How Expense Ratios and Star Ratings Predict Success

Here is a very valuable tool allowing a detailed comparison of any mutual fund with Vanguard alternatives. While Vanguard is no longer the only low cost player in town, their offerings are still always worth checking out before making a decision.

Cost Comparison Tool

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