The Worst Investment I've Ever Seen

In the interest of full disclosure, the absolute worst investment I've ever seen is an advance-fee offer from a long-lost Nigerian pen pal named Dr. Clement Okon -- a man who knows neither the proper use of a thesaurus nor how to turn off CAPS LOCK.

Just how bad is this investment? According to a report in The San Francisco Chronicle, "Dr. Okon" and his, er, colleagues bilked Americans for a record $198.4 million in Internet fraud in 2006 -- with the "notorious 'Nigeria 419' scam ... blamed for the largest individual losses."

When bad comes out of good
Although not as bad as the Nigerian scam, the worst stock market investment I've ever seen has also cost Americans a ton of coin -- but it's 100% legal.

Before I name names, some background: Index funds and exchange-traded funds are hugely popular. Hundreds of billions of dollars are tied up in index funds; the mammoth S&P 500-tracking Vanguard 500 Index (FUND:VFINX) alone holds more than $80 billion in total assets.

As I've written before, this is a decidedly good thing. With so many active funds failing to beat that one bogey -- the large-cap-laden S&P 500 -- while charging more in fees, betting with the house is a sound strategy. Indexing gives you instant diversification, low turnover, and, best of all, low costs.

So the theory goes
Take the very first index fund, for instance. Vanguard 500 has an expense ratio of 0.15%. It has no loads, 12b-1 marketing fees, or other hidden costs. So for every $100 you invest in Vanguard 500, you're dinged $0.15. Good deal, right? Hold that thought.

The First American Equity Index fund is also an S&P 500-tracking index fund. According to the fund's website, its objective is to "provide investment returns that correspond to the performance of the S&P 500 index." As you'll see, it's nearly identical to the Vanguard offering:

Data from Morningstar. VFINX holdings as of June 30, 2008; FAEIX holdings as of Sept. 30, 2008.

That's just a sampling. The allocations to smaller S&P 500 holdings such as Merck (NYSE:MRK), Comcast (NASDAQ:CMCSA), and Monsanto (NYSE:MON) will have about the same slight variance.

The holdings are almost identical -- and once the Vanguard holdings are updated through the last quarter, they'll be even closer -- but the fee structure is not. Here's what shares of First American Equity Index cost:

• 5.50% front-end load.
• 0.62% expense ratio (including a 0.25% 12b-1 fee).

Yes, you read that right: This is an index fund with a hefty front-end sales load and an expense ratio more than three times the size of its most notable competitor.

It's no small fry, either -- the fund has $1.1 billion in total assets.

More where that came from
I don't mean to single out First American Equity Index; it's not the only outrageously costly index fund:

Data from Morningstar.

High-fee index funds don't bring any performance advantages to the table, and they siphon off more of our money to the pockets of the fund companies. Indeed, Morningstar estimates that an investment of $10,000 in FAEIX will cost you $1,428 in fees over a 10-year period. That same investment in VFINX will run up $192 in fees. Do you see any reason to pay $1,236 more for the exact same product?

Me neither. And there you have it: The worst investment I've ever seen is the outrageously expensive index fund. Seriously. If you had two street vendors offering you the same product, and one of them charged substantially more, which would you choose?

That's a rhetorical question
In the marketplace, reason should lead us to the less-costly choice. But -- as the last column in the above table illustrates -- that's not the case with mutual funds.

In a paper titled "Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds," professors James Choi, David Laibson, and Brigitte Madrian reinforce that point.

The trio presented Harvard staff members and undergraduates and Wharton M.B.A. candidates -- a decidedly brainy sampling -- with a $10,000 portfolio. Each subject was to allocate the $10,000 across four S&P 500 index funds; the professors provided different groups with different information about the funds.

Now, the single differentiating factor among the choices is how much they charge -- they're S&P 500 index funds, for crying out loud! But the conclusions were sobering: "Many people do not realize that mutual fund fees are important for making an index fund investment decision. ... Second, even investors who realize fees are important do not minimize index fund fees."

Putting theory into practice
The fund companies justify the higher fees by saying that they come with financial advice/guidance. Here's the thing, though: If your broker isn't telling you to buy the cheapest index, you should be suspicious of that advice, anyway.

So make sure you're not unwittingly holding an index fund that'll slowly steal your dollars (pay close attention to your 401(k)s, in particular). And make double-sure you pay close attention to all of the fees you're paying when you invest. My colleague Robert Brokamp offers a wonderful service called Motley Fool Rule Your Retirement, and in his model portfolio section, he provides a short list of the best index funds around. To see the funds that have made the cut, and for retirement guidance of all stripes, I encourage you to try the service for the next 30 days, free of charge.

This article was first published July 3, 2008. It has been updated.

Brian Richards uses hyperbole sometimes. Brian owns shares of the Vanguard 500 Index fund, as well as Microsoft. The Fool owns shares of Pfizer. Microsoft, Pfizer, and Wal-Mart are Inside Value recommendations. Pfizer is also an Income Investor pick. The Motley Fool's disclosure policy is the greatest disclosure policy in human history.