For setting yourself up for long-term investing success, simpler is usually better. By focusing on the one factor you can control -- costs and fees -- you significantly increase the odds of improving your portfolio's returns.
But even if most actively managed funds didn't suffer from fee drag, there's little evidence that even professional money managers can consistently beat their benchmark. Over the past 20 years, 97% of all domestic funds underperformed their benchmarks.
That's why keeping fees as low as possible and simply trying to match an index instead of beating it has proven so appealing. The Vanguard S&P 500 ETF (VOO 0.11%) wouldn't be a surprising choice to beat actively managed funds this year, but its straightforward approach still makes it one of the best.
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Why VOO's low-cost structure wins
For most investors, simply owning the S&P 500 (^GSPC 0.16%), avoiding the temptation to try to pick winners, and letting the long-term power of compounding do the work for you is the best approach. By picking indexes instead of stocks, you're investing in the U.S. economy and the most successful companies that drive it.
We know that even professionals have trouble consistently picking outperformers. Retail investors often add poorly timed trading decisions to the equation, which usually ends up damaging potential returns even further. Long-term buy-and-hold investing simply has a better track record over time and works best for most everyday investors.
Plus, the Vanguard S&P 500 ETF's 0.03% expense ratio makes it nearly free to own. Since fees are one of the biggest obstacles to keeping up with benchmarks, this fund's ultra-low fee structure helps keep more money in investors' pockets instead of the issuer's.
NYSEMKT: VOO
Key Data Points
How fees add up over 20 years
If you're comparing two funds whose expense ratio difference is only a couple of basis points, the portfolio impact is probably inconsequential over short time frames. But when the expense ratio gap is larger and the time horizon is longer, it can result in thousands of dollars lost.
Let's use an example of two funds that both earn 10% per year before fees and expenses. Therefore, the Vanguard S&P 500 ETF and its 0.03% expense ratio would net a 9.97% average annual return. An actively managed fund with a 0.50% expense ratio would see its net return fall to 9.5%.
Even that modest difference in expenses results in a major difference in the ending account value.
| Input | VOO (0.03% expense ratio) | Active Fund (0.50% expense ratio) |
|---|---|---|
| Starting Value | $10,000 | $10,000 |
| Annual Rate of Return | 9.97% | 9.50% |
| Number of Years | 20 | 20 |
| Future Value | $66,909 | $61,416 |
Data source: Author's calculations.
In this example, investors lose roughly $5,500 over 20 years with the higher fee option. If the starting value was higher, the time horizon longer, or periodic additional investments are made over time, the amount of money lost could easily climb into the tens of thousands of dollars or more.
Paying higher fees for chronic underperformance with actively managed funds just doesn't make sense. Replacing it with a low-cost index fund, such as the Vanguard S&P 500 ETF, gives you broad exposure to the U.S. equity market without the fee drag. It's a simple solution and often the one that produces the best results for investors.
