We at The Motley Fool regularly extol the virtues of index investing, that is, choosing an investment that matches the performance of a broad-market index rather than picking individual stocks -- or paying someone to do so.
The success of this strategy is due partially to low costs. For example, the expense ratio (the percentage of an investment taken out to cover operating costs) on the Vanguard 500 Index Fund is just 0.18%, whereas the average expense ratio on an actively managed fund (one that pays people to pick stocks) is around 1.3%. Depending on the size of the investment, that one percentage point difference can add up to hundreds, if not thousands, of dollars.
When discussing index investing, we often cite the Vanguard 500 Index Fund as the prime example, and for good reason. It is the first and biggest index fund in the world, and it can be had without paying an upfront commission. However, as Fool Community member PaulEng recently argued on our discussion board, Vanguard's fee structure isn't that simple.
If your investment in the 500 Index Fund is less than $10,000, you'll pay a $10 annual account maintenance fee. If the balance drops below $2,500, you'll pay an additional $10 annual low-balance fee. Retirement accounts are not subject to the low-balance fee, but there is a $10 custodial fee for balances below $5,000.
The low-balance fees on nonretirement accounts and the custodial fees on retirement accounts are waived if the total amount of assets you have invested in Vanguard funds is $50,000 or more. However, regardless of how much you have at Vanguard, you'll pay the $10 account maintenance fee if you have less than $10,000 in the 500 Index Fund.
Got all that?
While paying $10 or $20 a year may not sound like much, it can add up -- especially if you have lower balances in several Vanguard funds because those fees are charged per fund, not per account. For example, let's say you had $8,000 in your Vanguard IRA, and it was all invested in the 500 Index Fund. You'd pay a $10 maintenance fee, but the IRA custodial fee would be waived since the amount is above $5,000.
However, if you decided to shift half of that money to the Vanguard Intermediate-Term Bond Index Fund (which has an expense ratio of 0.21% and also charges a $10 annual fee on balances less than $10,000), you'd now pay $40 a year -- two $10 maintenance fees and two $10 IRA custodial fees, since those balances would be below $5,000. Including all fees, the expense ratio on all your Vanguard investments is now effectively 0.70%.
We don't mean to pick on Vanguard. Its costs are among the lowest in the industry, and it's definitely not the only company that charges an array of fees. The real lessons here are: