Hat Tip to Alpha Architect.

When teaching investing to my students, I always emphasize the importance of fees.  While it is almost impossible to predict how my stocks/funds will perform in the future, it is very possible to know what fees will be this year if you read the prospectus. Oh, and they won’t change much in the future either.  This focus on fees usually takes me down the path of describing the advantages of passive investing (i.e., index funds) vs. active investing (i.e., picking a manager who you think can beat the  market).  See post here if you are interested in learning more about differences between active vs. passive investing.

So, what’s the catch?  Listed below is a fact sheet about the MainStay S&P500 Fund, which currently has over $2 billion in assets, not a trivial amount.  You might ask your students what stands out about this fund.  Ok, it is made simpler by the red boxes, which indicate a Sales Charge of 3% and Annual Operating Expenses of 0.60%.  Your student’s reaction might be “So what?”  

Now ask your students to find 2 other S&P500 Index Funds and compare their expenses to this one.  You cannot have more of a commodity product than an S&P500 Fund.  These funds will, with a very few exceptions, own the same stocks.  You are not buying the (purported) acumen of an active manager as there is little skill to managing a passive index fund (I hope I didn’t offend someone with that statement).

Your students will likely stumble upon the Vanguard 500 Index Fund (Vanguard is considered the king of index funds, I mean King) which carries NO Sales Charge and 0.17% Annual Operating Expense (0.43% lower than the MainStay Fund).  Why does this matter?  Well, if your students invested $5,000 per year for 20 years in each of these funds (and assuming a 7% market return), the results would be:

MainStay:

$5,000 investment reduced by 3% sales charge ($150) = $4,850

7% market return – 0.60% Annual Operating Expense = 6.4%

Vanguard:

No Sales Charge

7% Market Return – 0.17% Annual Operating Expense = 6.83%

So, when your students say the fees don’t matter…well, you can ask them this simple question:  Who likes to pay more for the same exact product?  In the scenario above, the Vanguard investors are ahead by almost $17,000. I hate investing predictions but I can’t resist with this one:  I can predict that the S&P500 index fund with lower fees will always lead to better returns.

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.