Location, Location, Location: Thoughts on Mutual Funds??

With a title like “Location, Location, Location” I’m sure most folks’ expectation is for commentary on the long-cited axiom in real estate investing.  But quite frankly, I am not a real estate expert and will leave that specialization to realtors and professional real estate investors.  However, I still believe “location” matters for the types of investment accounts that “house” people’s mutual fund or ETF investments.  Why?  It’s all about expense management.  In general, investors need to be aware of what funds are available in their 401(k) vs. other investment accounts (Rollover IRA, Traditional IRA, Roth IRA, and brokerage) and allocate their investments with a sharp eye on expenses because funds available in 401(k) plans are sometimes very expensive and as I detail below, expenses matter – a lot.

As most people know, mutual funds and ETFs come in an almost endless variety but can broadly be broken down into two big buckets- actively managed funds and passive funds (a.k.a. “index funds”).  Active bond or stock funds that attempt to “beat the market” by fund managers’ selecting stocks or bonds for a fund that the manager thinks will out-pace some benchmark index (i.e. S&P 500 index).  For that effort, investors (you and I) pay the mutual fund manager with the annual expense fee.  Conversely, index funds or ETFs do not try to pick stocks but instead just attempt to mimic market returns by including all the stocks (or bonds) in a particular index.  In the case of the S&P 500, that would be 500 of the largest companies (by weighted average market cap) in the US as designated by Standard & Poor’s.  Given there is minimal “effort” required to pick stocks in an index fund, they almost always have much, much lower expenses than actively managed funds.

The key here is that over a long term time horizon, most actively managed funds cannot overcome the disadvantage of the higher costs and typically under-perform simple market returns.  I could go into the reasons for this and cite the many books and academic studies that confirm it but for now, let’s just accept this as a key tenant to my broader point about where to “locate” your investments.

In analyzing families’ investments, it is very apparent to me that fund options within employers’ 401(k) plan can be narrow and not all that great and by that I mean, they often offer exorbitantly priced mutual funds for employees to invest.  For example, I recently reviewed a client’s accounts and noticed one “large cap domestic equity” fund in a client’s 401(k) plan where the fund manager was charging 0.42% per year. (Side note: this fund was the lowest cost option among all funds as the average expense ratio for the funds in the plan was almost double this at 0.82%.)  This compares to the Vanguard 500 Index Fund Admiral Shares (ticker: VFIAX) which, with a minimum $10,000 investment, charges 0.05% per year.

So, what’s the big deal on such a minuscule 37 basis point difference?  Not much for one-year but when you think about it in terms of price, would you rather pay $42 for a product that will likely under-perform a product you could get for $5?  More importantly, over a 20 year period and assuming a 6% nominal return for both funds each year, I estimate a $100,000 investment would grow to $296,233 for the “expensive fund” and $317,701 for the simple index fund or a difference of $21,469. With the “average” expense ratio of 0.82% the difference is $43,125 – real money if you ask me.

The good news is that large, low-cost custodians such as Fidelity, Schwab and Vanguard offer a wide range of low-cost index funds for use in qualified (i.e. tax advantaged) and non-qualified accounts.  (Full Disclosure:  I receive NO compensation or consideration of any type from these companies). This means a careful allocation of investment assets among your accounts can optimize expense management by choosing a diversification strategy which “houses” the funds that do the least “damage” (with high expenses) in the 401(k) accounts and then uses low-cost options in other accounts like Rollover IRAs, Traditional IRAs, Roth IRAs or brokerage accounts.  As an advisor who is not paid to gather assets (I don’t take custody of funds) nor do I get kick-backs from mutual fund companies to sell products, I take a top-down approach and maximize the cost efficiency across all family accounts- a significant cost advantage over time.  (I waited this long to put a plug in for myself….couldn’t resist).  More importantly, even if you chose not to use an advisor, you should be aware of this dynamic among your accounts.

The bottom line is that across the spectrum of a person’s or a families’ investment accounts, managing mutual fund expenses have one surprising commonality with real estate which is of course: location, location, location.

 

 

 

 

4 Comments

  1. Mr. Kure, thank you for your informative article; I decided to check the fees on my 401(k) after reading. I never checked before because I thought they would be hidden in some quagmire of information somewhere but it was actually quite simple. I discovered the fees for my Target Retirement Strategy 2030 were .54%. Based off information in your article I decided to check on the index fund option for my 401(k) and found that their Equity Index H fund only charged .05%. While checking on these fees I also discovered that the index fund has historically, from inception out performed the Target Retirement Strategy fund. So, I decided to “relocate” this morning and I feel like I learned something very valuable from your article. Thank you.

    Reply

  2. Mr. Kure, thank you for your informative article; I decided to check the fees on my 401(k) after reading. I never checked before because I thought they would be hidden in some quagmire of information somewhere but it was actually quite simple. I discovered the fees for my Target Retirement Strategy 2030 were .54%. Based off information in your article I decided to check on the index fund option for my 401(k) and found that their Equity Index H fund only charged .05%. While checking on these fees I also discovered that the index fund has historically, from inception out performed the Target Retirement Strategy fund. So, I decided to “relocate” this morning and I feel like I learned something very valuable from your article. Thank you.

    Reply

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