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Principle 3: Minimize cost

Principle 3: Minimize cost

CostMarkets are unpredictable. Costs are forever.

The lower your costs, the greater your share of an investment's return. And research suggests that lower-cost investments have tended to outperform higher-cost alternatives.

To hold onto even more of your return, manage for tax efficiency.

You can't control the markets, but you can control the bite of costs and taxes.

 

To show why it is essential to consider cost when choosing investments, we provide evidence that:

 
  • Higher costs can significantly depress a portfolio's growth over long periods.
  • Costs create an inevitable gap between what the markets return and what investors actually earn—but keeping expenses down can help to narrow that gap.
  • Lower-cost mutual funds have tended to perform better than higher-cost funds over time.
  • Indexed investments can be a useful tool for cost control.

Why cost matters

Minimizing cost is a critical part of every investor's toolkit. This is because in investing, there is no reason to assume that you get more if you pay more. Instead, every dollar paid for management fees or trading commissions is simply a dollar less earning potential return. The key point is that—unlike the markets—costs are largely controllable.

The illustration below illustrates how strongly costs can affect long-term portfolio growth. It depicts the impact of expenses over a 30-year horizon in which a hypothetical portfolio with a starting value of $100,000 grows an average of 6% annually. In the low-cost scenario, the investor pays 0.25% of assets every year, whereas in the high-cost scenario, the investor pays 0.90%, or the approximate asset-weighted average expense ratio for U.S. stock funds as of December 31, 2012.1 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



The long-term impact of investment costs
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.

 

The next illustration looks at the impact of costs in another way—by illustrating how they cause the return of investors in aggregate to trail the overall market return. It shows a bell-shaped distribution of returns, from lowest to highest, with the average return marked by a vertical line.

The impact of costs on overall investor returns
Hypothetical distributions of market returns before and after costs

The impact of costs on overall returns

Note: These distributions are theoretical and do not reflect any set of actual returns. Source: Vanguard.

In any market, the average return for all investors before costs is, by definition, equal to the market return. Once various costs are accounted for, however, the distribution of returns realized by investors moves to the left, because their aggregate return is now less than the market's. The actual return for all investors combined is thus the market return reduced by all costs paid. One important implication of this is that, after costs, fewer investors are able to outperform the markets (occupying the green area in the illustration above).

Reduce cost to help improve return

There are two ways to shift an investor's after-cost return to the right, toward the green region. The first is to earn higher returns than the average investor by finding a winning manager or a winning investment strategy (an "alpha" or "skill-based" approach).

Unfortunately, research shows that this is easier said than done (Philips, 2012). The second way is to minimize expenses. The list at the end of this article highlights five studies evaluating the impact of costs on performance. The common thread among them is that higher costs lead to worse performance for the investor.

The illustration below compares the ten-year records of the median funds in two groups: the 25% of funds that had the lowest expense ratios as of year-end 2012 and the 25% that had the highest, based on Morningstar data. In every category we evaluated, the low-cost fund outperformed the high-cost fund.

Lower costs can support higher returns
Average annual returns over the ten years through 2012

Lower costs can support higher returns

Notes: All mutual funds in each Morningstar category were ranked by their expense ratios as of December 31, 2012. They were then divided into four equal groups, from the lowest-cost to the highest-cost funds. The chart shows the ten-year annualized returns for the median funds in the lowest-cost and highest-cost quartiles. Returns are net of expenses, excluding loads and taxes. Both actively managed and indexed funds are included, as are all share classes with at least ten years of returns. Source: Vanguard calculations using data from Morningstar.

 

Indexing can help minimize costs

If—all things being equal—low costs are associated with better performance, then costs should play a large role in the choice of investments. As the chart below shows, index funds and indexed exchange-traded funds (ETFs) tend to have costs among the lowest in the mutual fund industry. As a result, indexed investment strategies can actually give investors the opportunity to outperform higher-cost active managers—even though an index fund simply seeks to track a market benchmark, not to exceed it. Although some actively managed funds have low costs, as a group they tend to have higher expenses. This is because of the research required to select securities for purchase and the generally higher portfolio turnover associated with trying to beat a benchmark.2

Asset-weighted expense ratios of active and indexed investments

Cost comparison

Notes: "Asset-weighted" means that the averages are based on the expenses incurred by each invested dollar. Thus, a fund with sizable assets will have a greater impact on the average than a smaller fund. ETF expenses reflect indexed ETFs only. We excluded "active ETFs" because they have a different investment objective from indexed ETFs. Source: Vanguard calculations, using data from Morningstar Inc.

 

There is much data to support the outperformance of indexed strategies, especially over the long term, across various asset classes and sub-asset classes. The illustration below shows how low-cost index funds as a group bested actively managed funds within common asset categories over the ten years through 2012. It provides the results in two ways: first, measuring only those funds that survived for the entire decade; and second, including the funds that disappeared along the way.3 The illustration shows how difficult it can be for active managers to outperform indexed funds.

Percentage of active funds outperforming the average return of low-cost index funds over the ten years through 2012

Outperformance

Notes: Data cover the ten years ended December 31, 2012. The actively managed funds are those listed in the respective Morningstar categories. Index funds are represented by those funds with expense ratios of 20 basis points or less as of December 31, 2012. All returns used were for the Investor share class. Sources: Morningstar and Vanguard.

 

The results are especially telling when they account for funds that were closed or merged during the ten-year period. Research has shown that low costs, inherent in passive investing, are a key driver in the long-term outperformance of indexed portfolios (Philips, 2012).

Tax-management strategies can enhance after-tax returns

Taxes are another potentially significant cost. For many investors, it may be possible to reduce the impact by allocating investments strategically among taxable and tax-advantaged accounts. The objective of this "asset location" approach is to hold relatively tax-efficient investments, such as broad-market stock index funds or ETFs, in taxable accounts while keeping tax-inefficient investments, such as taxable bonds, in retirement accounts. In the fixed income markets, tax-sensitive investors with higher incomes can consider tax-exempt municipal bonds in nonretirement accounts.4

The key take-away

Investors cannot control the markets, but they can often control what they pay to invest. And that can make an enormous difference over time. The lower your costs, the greater your share of an investment's return, and the greater the potential impact of compounding.

Further, as we have shown, research suggests that lower-cost investments have tended to outperform higher-cost alternatives.

Higher costs make for unhappy news: Studies document effects on performance

1996 Martin J. Gruber, in a study on growth in the mutual fund industry, found that high fees were associated with inferior performance, and also that better-performing managers tended not to raise fees to reflect their success. After ranking funds by their after-expense returns, Gruber reported that the worst performers had the highest average expense ratio and that the return differences between the worst and best funds exceeded the fee differences.
1997 Mark Carhart followed with a seminal study on performance persistence in which he examined all of the diversified equity mutual funds in existence between 1962 and 1993. Carhart showed that expenses proportionally reduce fund performance.
2002 Financial Research Corporation evaluated the predictive value of various fund metrics, including past performance, Morningstar rating, alpha, and beta, as well as expenses. The study found that a fund’s expense ratio was the most reliable predictor of its future performance, with low-cost funds delivering above-average performance in all of the periods examined.
2010 Christopher B. Philips and Francis M. Kinniry Jr. showed that using a fund’s Morningstar rating as a guide to future performance was less reliable than using the fund’s expense ratio. Practically speaking, a fund’s expense ratio is a valuable guide (although of course not a certain one), because the expense ratio is one of the few characteristics that are known in advance.
2011 Daniel W. Wallick and colleagues evaluated the associations between a fund’s performance and its size, age, turnover, and expense ratio. They found that the expense ratio was a significant factor associated with future alpha (return above that of a market index).

 

1. The asset-weighted expense ratio for all U.S. stock funds was 0.88% at year-end 2012, according to Morningstar.
2. Turnover, or the buying and selling of securities within a fund, results in transaction costs such as commissions, bid-ask spreads, and opportunity cost. These costs, which are incurred by every fund, are not spelled out for investors but do detract from net returns. For example, a mutual fund with abnormally high turnover would be likely to incur large trading costs. All else equal, the impact of these costs would reduce total returns realized by the investors in the fund.
3. For additional analysis regarding the performance of funds that have been closed, see Schlanger and Philips (2013).
4. See Jaconetti (2007) for an in-depth discussion of asset location, and Donaldson and Kinniry (2008) for discussion of tax-efficient investing.

 

Notes:

  • All investing is subject to risk, including possible loss of principal.
  • Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
  • Past performance does not guarantee future results.
  • There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
  • Diversification does not ensure a profit or protect against a loss in a declining market.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.
  • Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. Stocks of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets.
  • Prices of mid- and small-capitalization stocks often fluctuate more than those of large-company stocks.
  • Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
  • The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
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