Whether through mutual fund management fees or financial advisor fees, active investing is costing a lot to the average investor. It is no wonder that more and more assets are flowing towards index funds!
Investors wasted more than $100 billion over the last decade on expensive advice. – Warren Buffett
Over time, the 1 or 2 percent fee charged by money managers really compound to large sums. Considering that the average investor starts investing in their 20s and will be investing for decades ahead, that small fee adds up to a large portion of their hard-earned money. Using the Retirement Fee Analyser from Personal Capital you can quickly see how many precious years of retirement you are giving up to fees. In the example below, an investor paying 0.85% in average management fee actually lost 21% of his earnings over the 22 years he was saving for retirement. In his situation, he lost a whole 2 years of retirement because of fees.
No wonder some hedge fund managers can afford to burn $57.3 million on a house without blinking an eye! Fees add up and compound to hundreds of thousands of dollars, even for the average investors.
If you are currently investing in actively-managed mutual funds, you are playing a very costly game. The odds of success are so slim that you are better off simply investing in index funds and leaving them passively grow your wealth. The numbers do not lie, according to the S&P Indices Versus Active (SPIVA) scorecard, an astonishing 87% of large-cap fund managers underperformed the S&P 500 index over the past 5 years and 82% failed to beat the index over the last decade.
Building your own asset allocation in a portfolio of index funds will give you more control and flexibility over your finances at a much lower cost and has a much higher rate of success.
Let’s make a bet
To prove this point, a guy with a little more play money than me and Mrs. Xyz, Warren Buffett made a ten-year bet with a hedge fund manager from Protégé Partners. Buffett waged that $1,000,000 invested in the Vanguard S&P 500 index fund (VOO) would beat the top five funds pick from the manager. We are nine years in this bet and, so far, the winner is pretty clear.
Both large and small investors should stick with low-cost index funds. – Warren Buffett
To date, the passive index fund averaged annual gains of 7.1% and the five actively-managed funds returned an average of only 2.2%, compounded annually.
This means that the million dollars invested 9 years ago only returned $220,000 with the active funds and $854,000 with the index funds.
As shown above, the index may have started on a bad note with a yearly decline of 37% in 2008 but quickly recovered and outperformed the actively-managed funds after fees.
What can you do with $300,000?
With our personal investments, we aim to stay highly diversified and keep our cost to the minimum. We invest most of our assets with Vanguard given their hyper-low fees and their principles.
Markets are unpredictable. Costs are forever. The lower your costs, the greater your share of an investment’s return. – Vanguard
By controlling your cost, you can greatly save over the decades. According to Morningstar, the average equity mutual fund MER in Canada is 2.35% and the average account over the investment lifetime is $229,000. This tally up to an average management fee of $323,654.50 over a lifetime! Think about this figure for a minute.
The average equity mutual fund MER is more than 10 times more than Vanguard’s average expense ratio of 0.18%. This means the average investor losses roughly $300,000 to fees, and that is not including the tax impact that inefficient funds might trigger.
To put this number into perspective, on average, parents will spend up to $253,946.97 to raise their child up to 18, according to MoneySense. You don’t love your portfolio manager even more than your own children and he is not more important than your children so why pay him so much?
- With $300,000, me and Mrs. Xyz could become completely debt-free and still have $50,000 left over. This means owning our house outright and never paying any interest to the bank again.
- We could live like the 1.25 million people (8% of the working population) earning minimum wage in Canada if we would choose to live off 4% of $300,000. Using this safe withdrawal rate would be the equivalent of earning $11.53 per hour while working 40 hours a week all year-round.
- We could reduce our work hours and enjoy more free time or take more vacation weeks to travel the world. This would basically cover the cost of a hundred trips for us given what we currently spend on trips.
These options would all be missed if we invested in actively-managed mutual funds but we rather chose to optimize our returns and minimize our costs by investing in index funds. You can do the same in your 401k (RSP) selection, Roth IRA (TFSA) or unregistered accounts.
If you do not already have a self-managed investment account, you can open one today with Ally. For Canadians like us, Questrade offers free trades on exchange-traded fund purchases (ETF) and very low commissions on sells.
We hope you find your way to low-cost investing and best of luck, Xyz.