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Costs matter, and investors are getting the message

June 06, 2013

It's been three years since Vanguard Investment Strategy Group issued Costs matter: Are fund investors voting with their feet?, a research paper that examined the relationship between mutual fund costs and the behavior of investors.

Given Vanguard's passionate commitment to keeping investment costs low, what we learned back in 2010 was music to our ears. Not only did investors favor lower-cost funds—whether conventional mutual funds or exchange-traded funds (ETFs), stock or bond funds, passive or actively managed—they did so enthusiastically. Based on cash-flow trends across the industry, investors truly appeared to be "voting" in favor of lower-cost funds.

We recently reviewed and updated our research, and the passage of time hasn't changed our original conclusions. If anything, we think the trend toward lower-cost fund options looks even more pronounced today.

About our methodology

For our analysis, we examined monthly fund-level cash-flow data from Morningstar Inc., an independent fund rating organization, for the 10 years ended December 31, 2012. Within each fund category, we grouped the funds into four quartiles based on their annual expense ratios and calculated the net cash flows for each quartile.

You can read a high-level summary of our findings below, or you can download the full research paper.

Equities: A decisive edge for low-cost funds

Let's start by looking at the cash flow track record for U.S. stock funds and stock ETFs.

In the first chart below, the blue line represents monthly cash flows into the least expensive funds and ETFs. For this group, "Quartile 1," the average asset-weighted expense ratio was 0.44%—in other words, the average fund in that category charged its shareholders $44 each year for every $10,000 they'd invested. The other lines represent the upper three quartiles, with average expense ratios ranging from 1.04% to 1.90% (that is, annual charges of $104 to $190 per $10,000 invested).

As you can see, the lowest-cost funds were the heavy favorite, with $292 billion in cumulative cash flow from 2002 through 2012. The higher-cost fund categories, on the other hand, suffered a cumulative cash outflow of almost $370 billion. The bottom line? The lowest-cost quartile of funds attracted 100% of the positive cash flow during this period, while the three higher-cost quartiles all saw money flow outward.

Cumulative net cash flow for all U.S. stock funds and ETFs

Chart 1

Notes: Expense ratio quartiles were calculated annually. Shown for each quartile are the 2012 asset-weighted average expense ratios, determined by multiplying the annual expense ratios by the year-end assets under management and dividing by the aggregate assets in each quartile. Sources: Vanguard calculations, using data from Morningstar, Inc.

Next, we refined our analysis by examining just the funds in Quartile 1—the least expensive group—and breaking them down into four quartiles, with average asset-weighted expense ratios ranging from 0.17% to 0.87%.

Not surprisingly, the "lowest of the low" funds, represented by the blue line, came out on top here, with $449 billion in net positive cash flow. (Also worth noting: About 78% of the funds in this ultra-low subquartile were index funds or ETFs, capturing more than 84% of the $449 billion in net new cash from investors.)

Cumulative net cash flow for lowest-cost U.S. stock funds and ETFs

Chart 2

Sources: Vanguard calculations, using data from Morningstar, Inc.

Bonds: A similar preference for low-cost funds

The cost factor isn't limited to stock funds. Our analysis found that investors showed a decided preference for low-cost bond funds as well, possibly because of bonds' historical track record of lower average returns.

Once again, we divided the funds—in this case, taxable U.S. fixed income funds and ETFs—into four quartiles, with the lowest-cost funds (average asset-weighted expense ratio: 0.30%) represented by a blue line. And once again, it was the lowest-cost category that garnered the lion's share of new money. From 2002 through 2012, bond funds attracted $758 billion, of which $614 billion, or roughly 81%, went to the funds in Quartile 1. When you factor in the funds in Quartile 2 (average expense ratio: 0.65%), the two lowest-cost quartiles accounted for 95% of all new money going into bond funds. The bottom line: Although all four bond fund quartiles enjoyed positive cash flows during this period (possibly helped by periods of severe volatility in the equity market), investors clearly found lower-cost funds more attractive.

Cumulative net cash flow for all U.S. bond funds and ETFs

Chart 3

Notes: Expense ratio quartiles were calculated annually. Shown for each quartile are the 2012 asset-weighted average expense ratios, determined by multiplying the annual expense ratios by the year-end assets under management and dividing by the aggregate assets in each quartile. Sources: Vanguard calculations, using data from Morningstar, Inc.

As they did with equity funds, our analysts put the low-cost bond quartile under a microscope, breaking it down into four subquartiles, with asset-weighted expense ratios ranging from 0.12% to 0.53%. The result was the same: The "lowest of the low" turned out to be the winners in terms of cash flow, garnering $323 billion in net cash from 2002 through 2012—almost 53% of all new money invested in this category.

Cumulative net cash flow for lowest-cost U.S. bond funds and ETFs

Chart 4

Sources: Vanguard calculations, using data from Morningstar, Inc.

Vanguard's cost advantage—and why it matters

At Vanguard, low costs aren't just an abstract concept. Since our founding in 1975, we've offered mutual funds "at cost" as part of our core mission. Put another way, Vanguard provides its services to the Vanguard funds at-cost, and our funds cost our clients what they cost us. As of December 31, 2012, the average expense ratio for Vanguard mutual funds was 0.19%, while the industry average was 1.11%, according to independent fund rating agency Lipper Inc.

In an article written for last month, one of the research paper's coauthors stressed the critical importance of paying attention to investment costs.

Don Bennyhoff"While returns are out of investors' control, saving diligently and controlling costs aren't," wrote Vanguard senior investment analyst Don Bennyhoff. "For Vanguard, this message is central to both our investment philosophy and our company's DNA.

"We believe our focus on controlling costs has a lot to do with Vanguard's success," Mr. Bennyhoff wrote. "If even a small portion of investors in higher-cost funds were to move to lower-cost funds like Vanguard's, the 'wealth effect'—even when compounded at very modest rates—could be quite significant."

The illustration below shows how strongly costs can affect long-term portfolio growth. It depicts the impact of expenses over a 30-year period in which a hypothetical portfolio with a starting value of $100,000 grows an average of 6% annually. In the low-cost scenario (the red line), the investor pays 0.25% of assets every year, whereas in the high-cost scenario (the gold line), the investor pays 0.90%, or the approximate asset-weighted average expense ratio for U.S. stock funds as of December 31, 2012.* The potential impact on the portfolio balances over three decades is striking—a difference of almost $100,000 (coincidentally, the portfolio's starting value) between the low-cost and high-cost scenarios.

The long-term impact of investment costs on portfolio balances

Assuming a starting balance of $100,000 and a yearly return of 6%, which is reinvested.

Chart 5

Note: The portfolio balances shown are hypothetical and do not reflect any particular investment. The final account balances do not reflect any taxes or penalties that might be due upon distribution. Source: Vanguard.

Costs are one factor impacting total returns. There may be other material differences between products that must be considered prior to investing.

*The asset-weighted expense ratio for all U.S. stock funds was 0.88% at year-end 2012, according to Morningstar.


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