Did I Just Blow 20K?

4 minute read

…Over a decade and a half.  I know: bad trick, using the headline that way.

But seriously, almost everyone in the personal finance space now talks about how using low cost investing options is a good idea.  Put your money in index funds rather than actively managed mutual funds or with an adviser.

Why?

One word: fees.

Unfortunately, the investing world does not operate on the, “You get what you pay for” principle.

And, over the long haul, those little fees add up to be a drag on your returns.  How big of a difference?  Let me tell you a story…

My First Foray Into Investing

When I was 18, my Dad gave me a gift that I will never forget.  He started me (now us) on the path to financial independence.

When I was 18, I had my first W-2 job working as a sales associate in the electrical section of the regional hardware store.  (I worked for years before that, but I was always a small amount and paid in cash, so it was never eligible for taxation let alone retirement savings.)  At the then-minimum wage rate of $5.15/hr, I didn’t make much.  But, the little I made was reported to the government as earned income.  “Fortunately,” my earned income was so small, I was ineligible to pay taxes.

I was using the money I earned to pay for some of  my college expenses.  So, my Dad said he would match up to my earned income and put the money into something called a Roth IRA.  Of course, this became table stakes to hold a discussion on the general topic of saving for retirement.  We talked about the differences between a Roth and a traditional IRA.  We talked about contribution limits and the difference in withdrawal rules.  Once, we made it through the lecture, we got into the fun stuff: what to do with the money.  Pretty quickly, we ruled out a down payment on a car or storing it in my sock drawer.  Instead, he suggested investing in a mutual fund, The Growth Fund of America (ticker: AGTHX).  AGTHX is, you guessed it, an actively managed fund.  Its annual expense ratio (one of several potential charges people pay to invest their money) is 0.62%.

Active Fund Fees Are A Real Drag

So, why is that a problem?

If a typical index fund charges ~0.1% in fees, the observation is that actively managed mutual funds at ~.6% or a human adviser at ~1-2% don’t make you enough extra money in the long run to justify their cost.

Compare AGTHX to Vanguard’s S&P500 index fund (Admiral shares because we’re over $10,000).  The Admiral shares have an expense ratio of 0.04%.  While the Investor shares (minimum of $3000) have an expense ratio of 0.14%.  Last, I checked, 0.6% is more.

But, wait!  You say, “don’t the hotshot fund managers get a better return for their customers?”  How else can they justify charging more?

Maybe…

Let’s look at the numbers.

I used Morningstar’s portfolio analyzer to get a bit more information.  Note that it only looks at changes in share prices (no capital gains/dividend reinvestment included).  I simulated buying $100,000 of each fund on Jan 5 of 2001.  How have the two funds done over the past ~20 years?

Ouch. Let’s make this even more apparent. If you look at a Google Finance image of the two mutual funds’ values over time, it looks kind of like this:

So, what gives?  At almost no point in the past 20 years was AGTHX returning a higher rate than VTSAX. I think this illustrates something called “reversion to the mean”.  That’s fancy talk for an idea that most investments eventually deliver average performance.  They may out/under perform for years or a decade and a half, but eventually, they produce average results.  This is one of the core reasons for selecting low-cost index funds as your primary investment vehicles.  Over the long haul, if most funds perform similarly, then the lowest cost fund wins. You can read a lot more about this from John Bogle, inventor of the index fund, founder of Vanguard, and personal hero.   While AGTHX may have outperformed VTSAX before the internet was widespread, in more modern history, VTSAX has outperformed. Yet, AGTHX consistently charges fees that are almost 10x higher. What?

By the way, those fees are pretty insidious.  If you look at your statements, you will not see actual dollar values coming out of your account.  Instead, the fund management team takes them off the top before they show up in any individual statements (I spent a few hours looking through some pretty arcane sections of both American Funds and Vanguards websites before I convinced myself of this).

Deciding To Make A Change To Indexing…Or Maybe Not

So, now the conundrum.  I admit, it’s an emotional one.  Math says, roll everything from AGTHX into a lower cost fund (e.g., VTSAX).  Our goal is not to tap these funds for at least a few decades.  So, shedding the fees should be the right decision.  But emotion says maybe those über-smart folks at American will outperform the index once again.  And, what about diversification?  If hackers get into Vanguard, they may not simultaneously get into American.  And besides, my Dad is the one who got this ball rolling, even if I’ve done the vast majority of the contributions.  I feel some (totally irrational) guilt at moving away from this fund.

So, what to do?  I’d love some other perspectives…drop me a line in the comments.