In my short investment journey, I have read books, articles, and blog posts about the merits of index funds. “Invest in index funds”, they say, “and stop wasting your money on management fees!” Are the authors really telling the truth?
The idea behind an index fund is simple enough: all it does is track the performance of its underlying index. The operation of an index fund is also simple: all it has to do is buy and sell stocks to keep in line with actual market activity.
There is no need for a team of highly skilled professionals when it comes to an index fund, since the buying and selling is driven by the overall market activity. This results in lower management expense ratios (MERs).
Actively managed funds, on the other hand, aren’t just content with matching the index: they seek to actively beat the index. They have a highly skilled team which spends a lot of time researching, building complex computer programs and models, and focuses a lot of activity into buying and selling.
Sometimes, all of this activity and research pays off, and a fund manages to pull ahead of the market. Some even get lucky and manage to do it for a few years. Unfortunately, all of that skilled expertise and active buying and selling results in higher management fees and taxes, which hurts overall returns.
With a combined disadvantage of higher MERs and higher taxation due to higher turnover, active funds eventually succumb to the superior compound growth of index funds.
So, how do management fees impact overall returns? Just check out the following chart, which shows what happens to your investment under different fee levels.
For this chart, we assume that our market investment returns 10% year over year. On this return, we have three different funds: The Vanguard index fund, with a MER of 0.20%, an equity mutual fund, with a MER of 1.50%, and a high-fee mutual fund (such as you might find at your bank), with a MER of 2.50%.
On an initial investment of $1000, the market returns about $45,000. The Vanguard index fund loses very little with its small MER and does almost as well as the market. On the other hand, your standard equity mutual fund and your standard high-fee actively managed fund perform much worse after management expense ratios are taken into account.
If MERs were the only downside of actively managed funds, then there might still be a strong case for them. After all, they claim to be able to spot market problems before they occur, and therefore protect you from losses. If that were true, then actively managed funds could still be a good play. History, however, shows that navigating the markets can be like swimming in shark-infested waters, even for the pros, and the sharks can have a mean bite.
So why doesn’t everyone just switch over to passive funds?
Well, for one, many people aren’t content with receiving merely market returns. Many people truly believe that with the right research, skill, and a little bit of luck, they can leave the market in their dust. Some investors have had success doing so, themselves, but then again, they are not paying management fees to themselves, and many investors are not able to keep this up over the long term.
If everyone were to switch to index funds tomorrow, then there might be a problem. Index funds rely on active market movement in order to function. If everyone is just sitting around and nobody is actually actively buying and selling stocks, then how do you determine price and value?
The great thing about passive index funds is that so long as some people continue to believe that they can beat the market and invest in active funds, they will continue to work. With an index fund, you can benefit from all of the activity on the markets, without having to pay exorbitant management fees along the way.
The Canadian experience
Here is a quick rundown of some mutual funds available at Canadian banks, and their corresponding MERs.
|BMO Mutual Funds||MER|
|BMO Equity Index Fund||1.00%|
|BMO U.S. Equity Index Fund||1.10%|
|BMO Dividend Fund||1.70%|
|BMO LifeStage Plus 2030 Fund||2.73%|
|RBC Mutual Funds||MER|
|RBC Canadian Index Fund||0.68%|
|RBC U.S. Index Fund||0.69%|
|RBC Canadian Equity Fund||1.97%|
|RBC Balanced Growth Fund||2.26%|
|TD Mutual Funds||MER|
|TD Canadian Index||0.31%|
|TD US Index||0.33%|
|TD Balanced Index||0.83%|
|TD Canadian Equity||2.07%|
To add insult to injury, many of these high MER funds also have additional fees associated with them, such as “Deferred Sales”, “Front End”, “Back End”, and “Low Load”. With so many factors against you, along with advisors skilled at making you feel dumb, it’s no wonder why many people become bitter with the markets.
Investing It Wisely
I recommend a core portfolio of index funds, with the lowest MERs you can get and never with any additional fees. Please see the posts Living to 100 and Beyond: Building an Infinite Portfolio and Living to 100 and Beyond: Building Your Portfolio for more on these points.
So, what do you think about investing with index funds? I find that they are a little controversial even today, but the performance is there, and the low fees and expenses cannot be beat!