“If the return is high, do expenses matter?” I get that question a lot. So, I’m sure, do other personal finance columnists. The answer is simple, but not helpful.
“Yup, if the return is high, expenses don’t matter.”
Combine this wisdom with only buying stocks when the prices are low and selling them when the prices are high, and you’ve got it made.
The problem here is that both notions are after the fact. If you’ve had a high return, expenses don’t matter. And you can sell stocks at high prices only after first buying them low. Worse, while lots of people claim to have a way of providing high returns by selling stocks at high prices after they have bought them at low prices, they charge a lot for their clairvoyance, don’t provide guarantees and get paid regardless of performance. It works for them.
That’s why I’m such an annoying pest about investing expenses. The cost of managing your investments has consistently turned out to be the best way to increase the odds that you’ll have better returns.
Let me demonstrate a method I first used nearly 30 years ago. Back then Morningstar was a small company, not the financial data powerhouse that it is now. Indeed, it was so small that its database product was distributed through an agreement with BusinessWeek magazine. The service mailed floppy disks to subscribers, back in the early days of DOS.
Honk if you remember floppy disks, and feel grounded in historical knowledge if you know what they are.
The performance-versus-costs test is very simple. Select all the mutual funds in a category with 15-year histories and have the software calculate the average net expense ratio and the average 15-year annualized return. Then have the software select all the funds with above-average expense ratios and calculate the 15-year annualized return for that group. Finally, do the reverse: Select all the funds with below-average expense ratios for the category and calculate the 15-year return for that group. Then compare the numbers.
By the way, don’t worry if you hate arithmetic. The software did all this sorting and averaging for us. It did it 30 years ago. It does it today, but lots faster.
So what do you learn when you do this? In every category, funds with above-average expenses have an average return that is lower than the category average and still lower than funds with below-average expenses. As Vanguard founder Jack Bogle likes to say, “Costs matter.”
Here are the results for major categories based on the 15-year time period ending Sept. 30:
• Domestic large-blend funds: Above-average expense funds returned 5.66 percent, below-average expense funds returned 5.82 percent. Here, the low-cost advantage is unusually small, a mere 0.16 percent. In most periods it is larger.
• Foreign large-blend funds: Above-average expense funds returned 5.13 percent, below-average expense funds returned 6.43 percent. Low-cost advantage: 1.30 percent.
• Emerging markets funds: Above-average expense funds returned 10.82 percent, below-average expense funds returned 12.63 percent. Low-cost advantage: 1.81 percent.
• World stock funds: Above-average expense funds returned 6.63 percent, below-average expense funds returned 7.52 percent. Low-cost advantage: 0.89 percent.
• Moderate allocation funds: Above-average expense funds returned 4.92 percent, below-average expense funds returned 6.03 percent. Low-cost advantage: 1.11 percent.
• World allocation funds: Above-average expense funds returned 5.38 percent, below-average expense funds returned 7.07 percent. Low-cost advantage: 1.69 percent.
• Intermediate-term government funds: Above-average expense funds returned 3.93 percent, below-average expense funds returned 4.61 percent. Low-cost advantage: 0.68 percent.
• Intermediate-term corporate funds: Above-average expense funds returned 4.66 percent, below-average expense funds returned 5.18 percent. Low-cost advantage: 0.52 percent.
• High-yield bond funds: Above-average expense funds returned 5.75 percent, below-average expense funds returned 6.66 percent. Low-cost advantage: 0.91 percent.
Yes, there is a pattern here. Mutual funds with above-average expenses have, on average, below-average returns. Mutual funds with below-average expenses have, on average, above-average returns. Think of this as an investing Eternal Verity.
Does this mean that selecting below-average expense mutual funds will lead you to the Lake Wobegon of mutual funds, a place where all the funds are above average?
Sorry, no. But it will increase the odds in your favor. And that’s a good thing.
Questions about personal finance and investments may be sent by email to scott@scottburns.com.