There aren’t too many iron-clad rules in investing. We don’t know what markets are going to do tomorrow, much less 20 years from now. It’s really hard to pick winners and losers from a basket of thousands of stocks and mutual funds.
But there is one rule that prevails over time: Cost matters. The more you pay a manager to invest your money, the less money you’ll make over time.
On its face, that seems counter-intuitive. If you’re paying a professional manager to watch and grow your money, shouldn’t they do much better than an amateur like yourself?
Sometimes that’s true, but it’s not the case most of the time. Higher money management expenses rarely translate into higher returns.
According to recent research by the Vanguard Group, there’s a “cost drag” on returns that is directly the result of professional management.
Vanguard researchers looked at returns from small-company funds for the decade ending December, 2015. They looked at returns for passively managed index and actively managed funds in this group. While passively managed index funds generally reflected market returns, they were sometimes out-performed by funds that actively traded.
The takeaway from the Vanguard study was that index funds tended to be close to returns produced by the market. And the higher the expenses, the worse the active funds performed. Investors weren’t getting better returns for the higher fees.
Although these results can present two conflicting pictures — some active funds can and do outperform index funds — there’s a better case for higher returns with index funds over time. Costs add up and can eat up returns, especially if a fund isn’t beating the market.
Even though you may score better returns year to year with a top-flight manager, the sticking point is knowing which manager is going to have a good year. That’s brutally difficult to predict.
The big downside in guessing which manager is going to outperform is that you’ll pay more money to do so — and it will hurt your overall returns. That cements the argument for index funds most of the time.
Writes Vanguard researcher Jim Rowley in summarizing his company’s study:
“The case for indexing doesn’t mean that indexing beats all active all the time. It means that indexing — and, in particular, low-cost indexing — gains an advantage because the costs associated with it tend to be lower than the costs associated with active management, so by that notion, low-cost indexing is designed to outperform the average active manager over longer periods of time.”
In two words, again “costs matter.” This applies to everything in investing whether you’re buying an annuity or the funds within your 401(k). Pay as little as possible for yearly management expenses.
Avoid commissions, “wrap” and 12b-1 fees. They will only hurt your returns. If you’re paying more than 0.50% annually in annual expenses for any mutual fund within a 401(k), 403(b), 457, 529 or IRA, you’re paying too much.
It’s ironic, but in investing, while you may think that active management should yield higher returns, rarely is that true over time. You simply don’t get what you pay for.
John F. Wasik is the author of "Lightning Strikes," "The Debt-Free Degree," "Keynes’s Way to Wealth"and 13 other books on innovation, money and life. Follow him on Twitter and Facebook.