It Sure Adds Up
Dennis Friedman | September 16, 2020
MY FINANCIAL advisor has been on a mission to reduce my investment costs. He’s been replacing my low-cost, broad-based index mutual funds with the exchange-traded fund (ETF) version. He believes this will improve my investment returns over the long run.
For instance, if you own Vanguard Total International Stock Index Fund—a mutual fund—you’re currently paying 0.11% in annual expenses. But Vanguard’s ETF alternative charges just 0.08%, equal to a savings of three cents a year for every $100 invested. That might seem small, but my advisor assures me it can translate into significant savings over time.
You purchase mutual funds directly from the fund company involved, with the price set as of the 4 p.m. ET market close, while ETFs can be traded whenever the stock market is open. I believe switching to ETFs is the right thing to do. But I had doubts about how large the savings would turn out to be. It’s hard to imagine saving three cents a year on every $100 can amount to a whole lot of money.
The upshot: Using NerdWallet’s mutual fund fees calculator, I decided to see how higher costs can impact a hypothetical $1 million retirement portfolio that enjoys 9% annual stock returns and 3% bond returns over a 25-year period.
I used Vanguard mutual fund and ETF expense ratios to determine the estimated 25-year cost, basing the calculation on a hypothetical portfolio with the following initial asset allocation: Vanguard Total Stock Market Index 35%, Total Bond Market Index 35%, Total International Stock Index 15% and Total International Bond Index 15%. Thereafter, no further money was added, and the portfolio wasn’t rebalanced.
Result? Check out the accompanying table. Keep in mind that the ETF cost excludes the modest sum you might lose to the bid-ask spread when you buy or sell an ETF. What can we learn from the table?
- Switching from mutual funds to ETFs is a worthwhile cost-cutting effort, saving $20,465 over 25 years.
- Vanguard Total International Stock, even though that position is less than half the size of Vanguard Total Stock Market, proves to be significantly more costly. Remember, fund fees are based on a percentage of assets, so you pay a larger dollar amount as your balance grows. That, it seems, is the price you pay to own a better diversified portfolio.
- When investing in higher-cost specialty funds, such as those focused on energy, real estate, gold and health care, you have to ask yourself whether they’re really worth the extra cost. In most cases, probably not. In the long run, you’re better off in low-cost broadly diversified funds.
- One of the most important things to remember about investment costs is that they compound, just like your investment returns, except this compounding is hurting you. You lose not just the costs you pay in any given year, but also the growth that this money might have enjoyed in future. It’s called “opportunity cost”—the loss of potential gain. For some investors, it could be tens of thousands of dollars.
- If you use a financial advisor, you should factor in that cost—on top of the fees you’re paying for your investments—to get a handle on your portfolio’s total cost. For instance, the current annual cost of Vanguard Personal Advisor Services is 0.3% of a portfolio’s value. For our hypothetical $1 million portfolio, that’s $3,000 just for the first year. Over 25 years, this cost will also compound—negatively. Is it worth paying for advice? The answer will vary with every investor. But it’s worth it to me.
Dennis Friedman retired from Boeing Satellite Systems after a 30-year career in manufacturing. Born in Ohio, Dennis is a California transplant with a bachelor’s degree in history and an MBA. A self-described “humble investor,” he likes reading historical novels and about personal finance. His previous articles include 11 Remodeling Tips, Trust but Verify and No Vacation. Follow Dennis on Twitter .
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