We've said it before, and we'll say it again: When it comes to mutual funds, fees matter. You might look at two funds -- one with a 1% annual expense ratio, and one with a 2% ratio -- and think that the returns they would give you wouldn't be so different. But you'd be wrong.
In SFO magazine recently, I ran across a beautiful illustration of this point. The magazine featured a table showing how much you'd make and how much you'd pay in fees for two investments -- an index fund with a 0.18% fee, and a "traditional mutual fund" with a 1.25% fee. The chart assumed that each fund would earn the market's historic annual average return of 10%, and it subtracted the fees from that. The chart also assumed that you started off with a $10,000 initial investment and added $2,000 each year.
In just 10 years, the index fund would leave you with $57,117, while the traditional fund would offer $53,162. Why the difference, when they're both earning 10%? Fees. Over the decade, you'd pay $695 to the index fund and a much more sizable $4,650 to the other fund. Over 20 years, you'd pay $4,483 to the index fund and $28,803 to the other fund. Is that latter sum sinking in? That's big money. Keep going, and after 40 years, you'll have paid a total of $70,921 in fees to the index fund, and . $419,178 to the other fund. You read that right -- not all that much less than half a million dollars!
My initial reaction is to snort at the ludicrous idea of paying more to earn less. But to be fair, the chart is set up to show that kind of result, as the funds earn the same rate, pre-fee. Someone could reasonably argue that an index fund is likely to give you just the market's return, and no more, and so over the long haul it shouldn't be expected to do much more than 10%, on average, if that. And meanwhile, "traditional" mutual funds (i.e., those actively managed by smarty-pants professionals) offer the possibility of greatly exceeding the market's return.
Of course, the bad news here is that so few funds do outpace the market, partly because of fees. That's why we've long recommended index funds for most investors. (You can learn a lot about mutual funds and index funds in our Mutual Fund Center.) Invest in an S&P 500 index fund, and your holdings will instantly include shares of 500 top American companies. Invest $5,000, and you'll have about $170 each in General Electric (NYSE:GE) and ExxonMobil (NYSE:XOM) stock, roughly $60 each in Altria (NYSE:MO) and Procter & Gamble (NYSE:PG), and some $44 each in Dell (NASDAQ:DELL) and Verizon (NYSE:VZ). Not to mention 494 other companies.
If you want to do better than the market, you'll have to look at managed funds and you'll have to pay annual expense fees higher than you can get with many index funds. Fortunately, there are a bunch of terrific funds out there, with solid long-term track records and attractive prospects. We'd love to introduce you to many of them, via our MotleyFoolChampion Funds newsletter. Try it free, and see which funds lead analyst Shannon Zimmerman is recommending this month and has recommended in the past. Together, his picks have nearly doubled the market's return (as of the last time I checked), gaining an average of 13%, versus 7% in the same time period.
Learn much more in these Zimmerman articles:
- The Case for Mutual Funds
- Slam-Dunk Mutual Funds
- You're Paying How Much?
- Champion Funds Still Beating the Market
- Three Reasons to Sell
- Is It Time to Sell?
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.
