Ask the grumpies: Fees vs returns

Julia asks:

How do you weigh the expense ratio for a fund vs their avg returns? I tend to go for lowest fee ETFs. My husband keeps suggesting that if a fund has overall higher returns that it is worth the slightly huger fee. I’m usually looking at funds with like 0.4% or less in fees. He probably wouldn’t go over 1% but still higher than me. Is the math as simple as if the returns are higher it’s worth the fees?

Disclaimer:  We are not financial professionals.  Please do your own research and/or consult with a certified professional planner before making any life changing money decisions.

Short answer:  You’re right, he’s wrong.

Longer answer:

High fees are usually caused by active management.  Less than 50% of actively managed funds match or beat the market.  That is worse than average!  (I don’t have the cite, but the study finding that came out/got highly publicized a little over 10 years ago.)  You are better off with a fund that matches the market it is indexed to.  Yes, sometimes you will get lucky with an actively managed fund, but on average you won’t.  And, for these actively managed funds, past performance doesn’t predict future performance.  It really is just that sometimes active managers get lucky and sometimes they don’t.

Fees can also just vary arbitrarily:  Brigette Madrian did an interesting study a couple of decades ago where she took a whole bunch of S&P 500 indexes from a bunch of different companies.  These all had the same underlying index, but they had different fees for whatever reason.  These funds also had different “returns since inception” which means that the indexes that were started earlier or the indexes that got lucky and were started when the S&P 500 was at a low point *looked* like they had better returns than did younger S&P 500 indexes or those started when the market was at a high.  But the actual investment option *was the same*.  The interesting thing was that University of Chicago MBAs looked at the advertising and chose based on “returns since inception” even though such a statistic was meaningless.  Even though the funds were identical except for their fees.

Fees will also vary for other reasons I don’t completely understand but are not necessarily linked to higher performances.  Bond funds seem to have higher fees than full market stock funds.  Foreign funds, emerging markets, REIT etc.  these all tend to have higher fees than a straight up S&P 500 or Total Stock Market Index.  But even though they’re higher fee and potentially lower return, they also mitigate risk in a large portfolio.  Bonds have lower returns but also don’t move the same direction stocks do.  Other markets may have more volatile returns but they don’t completely correlate with what’s going on in your standard S&P 500.

Bottom line:  Get a cheap index, and avoid actively managed funds.  When you’re starting out, get the lowest fee Total Stock Market Index or S&P 500 Index you can get (depending on your investment options– in some company plans, the S&P 500 is the *only* affordable index fund and you have to pay a premium to get a total market fund).  If you’re lucky enough to have a cheap Target Date Fund (from Vanguard, for example), you can just set that and forget.  If you don’t have good company options, contribute to the match and then save additional money in a Vanguard IRA (traditional or Roth).

Book recommendation for your husband:  Bogleheads Guide to Investing .

13 Responses to “Ask the grumpies: Fees vs returns”

  1. mnitabach Says:

    I’ve always assumed that when it comes to investing in publicly traded securities, at the professional level no one is any smarter than anyone else. So when you hear about BRILLIANT FUND MANAGER BEATS MARKETS FOR FIFTEEN YEARS IN A ROW it’s just that when there’s thousands of managers throwing shit against the wall at least a few are gonna get dumb lucky for years in a row. Sounds like this is basically what you’re saying, but is there any good statistical analysis to try to figure out whether any fund managers really are “smart” versus expected number of repeatedly dumb lucky?

    • nicoleandmaggie Says:

      Fund managers do worse on average than would be expected by random chance. So even if one or two are actually magic instead of just lucky there’s no way of knowing and they’re balanced out by the people who are worse than flipping a coin.

      We still can’t agree on whether or not there’s a hot hand in basketball– and that generally looks the same as flipping a weighted coin.

      • Michael Nitabach Says:

        Yeah I was thinking this is exactly the same question as basketball “hot hand” & baseball “hot bat”. I think WRT to baseball hitting streaks, there is at least some evidence they are not just random chance? It is interesting that fund managers on average do worse than chance.

      • nicoleandmaggie Says:

        Mixed evidence. Lots of papers saying it’s chance, a few more recent papers saying it isn’t.

      • nicoleandmaggie Says:

        Insider trading still works though.

  2. Matthew D Healy Says:

    A book written before I was born is still one of the best books about Wall Street. And its title conveys its message: Where Are The Customers’ Yachts?

    • nicoleandmaggie Says:

      Looks like that’s also one of Warren Buffet’s favs!

    • Michael Nitabach Says:

      Lolz yeah same principle as these bloviating sleazebags pretending to be “analysts” touting “investment strategies” on CNBC or whatever. Not only don’t they know anything, but they’re not just idiots. They are affirmatively LYING when they assert that they really believe what they’re recommending. Because if they actually believed their own bullshit, they’d be quietly acting on it themselves, not spouting it for free on teevee. It’s beyond comprehension how anyone can listen to any of that gibberish. Maybe you can make money doing the exact opposite of whatever Jim Cramer tells you to do on teevee?

  3. revanche @ a gai shan life Says:

    To back up this post with a real life example of this principle: A relative has a sum of money invested in an actively managed fund and the fees and active management means that the performance in the past decade has been so bad they’ve actually lost money. In *this* market. I buy and hold individual stocks in one portfolio and index funds in the other: I keep my fees low and my activity lower. I buy and that’s it. I’m no great mind at investing but either of my portfolios average a 12-14% personal rate of return. Theirs still only has the exact same amount of money they started with ten years ago. It’s absolutely astonishing.

  4. First Gen American Says:

    I talked to an investment person a friend loves last year, thinking again that maybe I should farm this out. His firm charges the standard fee…1% plus he manages the portfolio with a bunch of expensive mutual funds that also have fees so you’re double paying. Madness.

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