Not too long ago, I wrote a post about why the cost of investing matters so much to the individual investor.  In short, costs matter because they substantially erode your investing returns, and paying higher costs in no way guarantees you will receive higher long-term returns.

That’s why the long, slow downward trend in investing costs is worth writing about today.  You may have seen recent headlines that the costs charged by financial institutions are sinking to rock-bottom:

• Brokerage Wars Continue with Unlimited Free Trades
• Who Won the Zero-Fee Fund War?

The first article is mostly about brokerages no longer charging fees for buy and sell transactions.  The second article focuses on fund providers that recently started to offer funds with zero expense ratios.  (The expense ratio is the total of all fees and expenses charged by the fund provider while you hold a fund.  It’s usually expressed as a percentage of the dollar-value invested in the fund.)  What does the bottoming out of these two costs mean for individual investors?  Let’s take them one at a time.

Free Trades

There’s a long history of upstart brokerage’s undercutting the trading fees of the well-established brokerages.  Today, at least seven large companies offer free trades for stocks, bonds, exchange-traded funds, and mutual funds.

Free trades aren’t a huge game-changer for most investors because trading costs have been pretty minimal for years now.  Further, we mindful investors don’t trade much; we buy and hold for the long-term.  But we do have to buy fund shares regularly when we’re young and sell some shares to fund living expenses in retirement when we’re old.  So, avoiding even small toll charges for access to the markets is definitely a benefit to long-term savers and investors.

Also, mindful investors will often need to regularly reinvest dividends and periodically rebalance asset allocations.   Looking at these two portfolio maintenance activities through the new lens of free trades suggests I need to adjust some of my previous mindful conclusions about reinvesting and rebalancing.

Dividend Reinvestment – For years there have been several different ways to reinvest dividends for free.  So, my conclusions on reinvesting haven’t changed much with the advent of zero trading costs.  When trading costs were more common, reinvesting too frequently in small dollar-value accounts could substantially erode your long-term returns.  But now, because it’s so easy to avoid trading fees, reinvesting dividends as frequently as possible always helps compound your wealth.

Rebalancing – Previously, I had concluded that less frequent rebalancing (for example annually instead of quarterly) could generate higher after-cost returns in some cases.  But now with free trading, if you’re going to rebalance, you can do it as often as is logistically reasonable.  My long-standing caveats about rebalancing are still valid, including that:

• There’s no consistent benefit from rebalancing mixed stock/bond portfolios
• Rebalancing can boost the returns from all-stock portfolios, but this benefit is largely confined to portfolios with the most volatile and least correlated types of stocks.

Hidden Costs – Also, it’s worth noting that most of these brokerages still have hidden costs associated with each transaction.  The main hidden cost is that the brokerages may give you a share price that’s a little bit higher than the true market price.  The brokerage can then cash in on the difference between these two prices using nearly instantaneous computer trades.  Unfortunately, it’s nearly impossible to quantify how much this costs you over the long run.  So, you can regard these hidden costs as the unavoidable minimum required to invest in today’s markets and then forget about them.

Declining Fund Expense Ratios

The long slow descent of fund expense ratios mirrors the decline of trading fees.  Here’s a graph from Vanguard showing the history of average fund expense ratios.

Since about 1987 the expenses associated with stock and bond funds have been decreasing, with the industry average now approaching 0.5%.  And as the graph suggests, Vanguard’s below-average costs have been putting pressure on other fund providers to reduce their expenses.  As a result, we’re starting to see some major fund providers like Fidelity testing out zero expense index funds.

This trend doesn’t change any of the primary investing strategies discussed here at Mindfully Investing.  It’s still mindful to invest in a moderately diversified set of low-cost stock index funds.  It’s just that now you have an ever-greater selection of extremely low-cost, or even zero-cost, options to choose from.

What’s The Benefit?

The continuing trend in lower costs requires only minor adjustments to a mindful investing approach.  But what’s the aggregate benefit of these declining costs to individual investors?  The answer to that question depends to some extent on your specific situation.  So, out of sheer self-interest, I decided to look at an example that applies to an early retiree like me.

I retired at age 52 and given today’s life expectancy rates, I could easily live until age 92, which means 40 years of investing and living off the proceeds.  Other assumptions in my example include:

• A moderately diversified stock portfolio with an average expected future annual return of 5%
• A $1 million starting value
• A 4% annual withdrawal rate, inflation-adjusted at an annual rate of 2%

I then took this base case and calculated the account value over time using two different cost scenarios.  The “2010” scenario uses costs appropriate to about 10 years ago, and the “2020” scenario uses costs more in line with today.  Here are the details:

• • 2010 scenario – $10 fee for each trade, 4 trades per quarter for dividend reinvesting, 4 trades per quarter for rebalancing, and a 0.7% expense ratio across all funds in the portfolio.
  • 2020 scenario – $0 fee for each trade (so the number of trades is irrelevant), and 0.1% expense ratio across all funds in the portfolio.

The yellow and orange lines in this graph show the trajectory of the account values for both the 2010 and 2020 cost scenarios.  And for comparative purposes, the gray and blue lines show the growth of account values for the same two cost scenarios but assuming no withdrawals, which might be more interesting to un-retired readers.

Looking at 4% withdrawal scenarios, we can see that, with the new 2020 costs (yellow), our example retiree still has money after 40 years.  But with the old 2010 costs (orange), our retiree runs out of money around year 35.  So, the benefit of lower costs is that the same-sized nest egg will last several years longer into retirement.  Alternatively, you can reach the same investing goal with less money.

And if you’re looking at a pure growth scenario, the difference in account values between 2010 costs (blue) and 2020 costs (gray) is more than $1.3 million over 40 years!  Here’s a bar graph showing the end value of each scenario to better illustrate the outcomes.

Regardless of your specific situation, cost competition on Wall Street is putting substantially more money in your pocket over the long run.

Financial Adviser Costs

Trading fees and fund expenses apply to every investor.  However, some investors have even more expenses, the most common of which is the cost of using a financial adviser.  An adviser helps you with portfolio selection, maintenance activities, and picking funds, which will likely incur transaction fees and fund expenses.  But they also charge a fee on top of all that in return for their sage advice.

A working assumption of Mindfully Investing is that you’re a do-it-yourself investor and don’t use an adviser.  Although there’s nothing categorically wrong with using a financial adviser, the added costs need to be factored into your investing goals.  Michael Kitces summarized recent data on adviser costs and produced this graph.

In this case, the “underlying fee” shown in orange refers to the transaction fees and fund expense ratios that I covered in the first half of this post.  The “AUM fee” refers to the percentage that the adviser charges on top of the other costs.  So, it’s not unusual for a financial adviser to charge an additional 0.6% to 1%.   And therefore, even as recently as 2017, the all-in costs of using an adviser can get close to 2%!

If you add advisor costs to either of the withdrawal scenarios shown in the previous graphs, then you would run out of money before meeting a 40-year retirement goal.  Unless the decline in adviser costs catches up quickly to other decreasing costs, advisers are starting to represent the lion’s share of potential investing costs.  So, if you’re thinking about using an adviser (or already do) it’s increasingly important to examine how the adviser’s costs would impact your investing goals over the long term.

Opportunity Costs

I typically don’t write a lot about opportunity costs, because it can quickly become an economics quagmire about which costs to include and how to calculate them.  However, the interest rate on cash in your portfolio is one obvious opportunity cost that’s very relevant to “older” mindful investors.  I’ve argued “older” investors should hold up to 20% of their portfolio in high-interest cash accounts for 5 to 10 years bracketing their retirement date.  But most cash vehicles in brokerage accounts pay a pittance in interest.  For example, my brokerage pays 0.09% interest on cash, but my online bank is paying 1.7%, nearly 20 times higher.

So, it’s notable that Fidelity¹ (and probably some other brokerages) has recently started advertising interest rates for brokerage account cash in the 0.8% to 1.3% range.  Holding cash in a low-interest account is a lost opportunity cost that’s becoming increasingly easy to avoid.  Over the first 10 years of retirement, the difference in interest produced by $200,000 in an old low-interest versus a new relatively high-interest brokerage account is significant.  This table tells the tale.

Scenario (starting with $200K)	Account Value After 10 Years	Account Value After 40 Years
Old Interest Rate = 0.09%	$201,626	$207,141
New Interest Rate = 1.3%	$224,654	$330,977
Difference	$23,029	$123,836

This example isn’t super realistic, because it assumes simple compounding with no withdrawals or new deposits over time.  Nonetheless, it gives you a sense of the opportunity cost that can accrue in just 10 years.  And although it would be decidedly un-mindful to hold a cash bucket for 40 years, if you did, the opportunity cost of using an old-style cash brokerage account becomes relatively huge.

Conclusions and The Future

Clearly, searching out the lowest investing costs is still inherently mindful and can help you attain your investing goals.  But because costs are continuing to decline across the board, a relatively low-cost option from yesterday may morph into a relatively bad deal by tomorrow.  For this reason, it makes sense to do some comparison shopping about once a year on brokerage account fees and fund expenses.  The more you can drive down your costs, while sticking to a mindful investing plan, the greater your chances of success.  But don’t forget to consider the tax implications of selling one fund for another lower-cost fund, particularly if your working in an account that’s not tax-advantaged.

When I first started dabbling in stocks in the early 1990s, few people questioned the idea that you might have to pay $100 for a single transaction or 2% in fund expenses.  But today, those costs seem preposterous.  And so, I wonder how extreme these cost trends may get in the future.  Some companies have started trying out funds with negative costs.  This means the fund providers pay you to buy their funds!

Whether negative costs will become a standard offering from the fund industry has yet to be seen.  But to some extent, reversing the flow of investing costs makes sense to me.  I always wondered why the bank will pay you interest to hold your money², but brokerages, fund providers, and financial advisers make you pay for the privilege of potentially losing all your money in the markets.

Why shouldn’t these investing companies pay you for holding your money just like the banks do?  The company that invents a way to make a consistent but modest amount of money from assets under management while paying investors a few pennies above and beyond at-risk market returns will disrupt the entire finance industry.  Although I’m not sure a scheme like that is even allowed under today’s finance regulations, I’d be very interested in participating, assuming a reputable firm was involved.  But until then, we’ll just have to content ourselves with diligently exploiting and pocketing the additional returns that come with the long, slow decline of investing costs.

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1 – I have no affiliation or advertising relationships with Fidelity.  I just happened to notice their adds on television.  I’m sure Fidelity won’t be the only brokerage trying to attract customers this way, and the options for higher interest brokerage accounts will likely be expanding soon.

2 – Of course, when the Fed started severely cutting interest rates in the 2000s, banks cut depositor interest payments, and they’ve never really recovered.   While bank interest today is best viewed with a magnifying glass, it’s still better than paying the banks to hold your money.

I just received an annual statement from my 401K retirement plan showing the costs of the various funds the plan offers.¹  If you have an employer-operated 401K or similar retirement plan, you may have wondered why you get this cost statement each year.  My statement says it’s because of Department of Labor regulations, but I give the real credit to John Bogle.  He invented the index fund in 1975 and founded Vanguard, an investment services company that has grown into the largest index fund provider in the world.  Throughout his life, Bogle championed more transparent and lower fund costs, and as a result, he saved a whole generation of individual investors tons of money.  He died at the age of 89 in January of this year.

Regarding the fees and other expenses that all investors pay to mutual and exchange-traded fund (ETF) providers, Bogle said this:

• “In investing, you get what you don’t pay for.  Costs matter.”

What exactly did Bogle mean by this?  After all, couldn’t it make sense to pay an expert for additional returns that exceed the fees charged?  Bogle pointed out at least two important reasons why costs matter:

1. Costs erode returns substantially over the long term.
2. Funds with higher costs often produce lower returns.

I briefly covered these two cost issues in a previous post.  But I think it’s worth commemorating the passage of John Bogle by taking a closer look at these two issues.  My recent 401K statement provides a good way to examine the real-world cost choices that individual investors face.

Costs Erode Returns

My 401K statement lists the “expense ratios” of all the funds offered in the plan.  An expense ratio includes all the costs the fund charges, expressed as a percentage of money invested in the fund.²  The expense ratios for the funds in my plan range from 0.04% to 1.31%.

An expense ratio of even 1.3% may not sound like much.  But look at this graph showing how much the 30-year growth of $10,000 is slowed by these seemingly small expenses.

This calculation uses monthly compounding of the historical average annualized return of the stock market (about 9%) and then subtracts out the expenses.  In this case, the lowest expense ratio yields $45,000 more in final value as compared to the highest expense ratio.  In other words, with the highest expense ratio, 37% of the potential return goes to the fund provider.

You see quite a few of these comparisons on the internet.  But they’re somewhat misleading because they unrealistically assume a one-time investment contribution.  A more realistic comparison is to calculate the compounding associated with monthly contributions.  Here’s a similar graph but assuming monthly contributions equal to $19,000 per year, the maximum allowed under U.S. law.

Even with this more realistic scenario, the difference between the lowest and highest expense ratios is about 26% of the final value.  And that equals a whopping $650,000 in lost returns over 30 years!

However, this scenario is still pretty misleading.  Specifically, no 401K plan intentionally offers two identical funds with widely disparate expense ratios.  My 401K plan offers a more realistic example of the kind of fund choices and range of costs that most investors encounter.  But before we explore those choices, let’s look at Bogle’s second complaint about fund costs.

Higher Costs Often Produce Lower Returns

Many studies have looked at the relationship between fund costs and returns.  Here’s a chart from one study by Vanguard that looked at costs and excess 10-year returns associated with small-cap blend funds.  “Excess returns” refers to the amount of return above a comparable index benchmark.

Charts like this are used to argue that higher costs are correlated with lower returns.  But in all fairness, the data are very scattered.  Although no coefficient of determination (a measure of correlation strength) was provided for this chart, I suspect the negative correlation is quite weak.  On the other hand, these data clearly show there’s no positive correlation between higher costs and higher returns.  Another Vanguard study assessed a wider variety of stock funds as shown in this graph.

The picture is remarkably consistent across all types of stock funds.  There’s a weak negative correlation between excess returns and costs but with a large scatter in the data.

Morningstar looked at this question another way using a “success ratio”, which counts the proportion of funds that survived (stayed in business) and achieved better returns than the average of all funds in the same category.  Here’s the key graph from that study looking at 5-year returns.

They split all funds in each category into five groups (quintiles) arranged from low to high cost.  The success ratio for the lowest cost quintile was in the 50% to 60% range across the categories, while the success ratio was only in the 15% to 25% range for the highest cost quintile.

Now we can start to see why Bogle said, “you get what you don’t pay for”.  All other things being equal, the more you pay in fees and expenses, the more likely your returns will be diminished.

Limited Choices

This is pretty much where I’ve stopped my cost analysis in previous posts.  But while looking at my 401K statement, it struck me that many investors don’t have free reign to pick any fund (or combination of funds) in the world.  Given that 401K plans (and similar 403b plans) are among the most common tax-deferred retirement accounts, many folks have far fewer options.

For example, my 401K plan offers 32 fund choices, 12 of which are target-date funds, which are nearly identical except for the ratios of stocks to bonds.  The rest of the funds include several bond funds as well as stock funds that focus on international stocks, different stock sizes (large cap to small cap), and different stock styles (mostly growth versus value).  What’s the correlation between expense ratio and excess 10-year returns within this limited set of choices?  Here’s the graph.

The relationship between cost and excess returns is essentially random, with a coefficient of determination that’s less than 0.01.  (A value of 0 indicates no correlation and a value of 1 indicates a perfect correlation).  So, within my 401K plan, higher costs don’t predict lower returns.  But more to the point, costs don’t predict anything useful about returns.  Paying for expertise that has a coin flip’s chance of success is pretty irrational.  You might as well flip the coin yourself and keep the fees in your pocket.

Uncertain Returns

However, you probably noticed the handful of relatively expensive funds in my 401K that had excess 10-year returns in the 2% to 3% range.  Because all the returns reported for my 401K factor in costs, some of these funds have provided excess returns over the last 10 years well beyond the fees they charged.  Why not pick one of those funds and reap the additional returns that aren’t available from index funds?

One of the most pervasive warnings from investment companies is: “Past performance is no guarantee of future results”.  It’s such an old cliche that we can become numb to its true meaning.  In this case, 10 years of excess returns are no guarantee of another 10 years of excess returns.

In fact, I’ve summarized loads data in the pages of Mindfully Investing showing that past high fliers tend to crash and burn moving forward.  And despite the existence of a few superior performing funds in any given period, between 80% to 95% of all funds regularly fail to outperform their benchmarks.  Picking the most recent high flier is such a common mistake that it’s pejoratively known as “chasing performance”.  Investors rush to the hottest table in the casino only to find the luck has gone cold after they place their bets.

The basic choice faced by 401K investors is whether to buy the safe low-cost index fund, which guarantees middling returns (0% excess return) or pay additional fees and take a chance on the most recent hot performer.  From the way I’ve set this comparison up, you already know which is the more mindful choice.  But here’s some proof using my 401K as an example.

Examining returns over one or two periods (my 401K statement provides 1-year, 5-year, and 10-year statistics) only gives you a snapshot of a fund’s ongoing performance.  What if we instead examined returns over many periods?  There’s a lot of different ways to do this, but I chose to compare 5-year rolling annualized returns for the life of several of the funds in my 401K plan³ including the three stock index funds (large-cap, mid-cap, and small-cap funds) and the most similar (not identical) actively managed funds offered in the same plan.  Here are the graphs for each of these comparisons based on fund stock size.

Years shown on the horizontal axes indicate the end of each 5-year period.  Dotted lines indicate periods when excess returns for the active funds dipped into negative territory, which means that the index fund performed better than the active fund.  There were two similar active fund choices for mid-caps in my plan, so I compared both active funds to the mid-cap index fund.

Three out of the four active funds shown above underperformed the index funds about half the time.  For example, if in 2013 and you picked my plan’s active large-cap fund because of its recent hot streak, you would have been disappointed by negative excess returns up through today.  I’ll note that the mid-cap graph shows that the active fund represented by the orange line has done pretty darn well for nearly 18 years.  But even that fund started with a 5-year excess return near -3%, and there’s no guarantee that its recent superior performance will continue.  Researchers have consistently failed to find ways to predict which active funds will have superior future performance.

Conclusions

My 401K plan nicely illustrates that even when you’re faced with a limited set of options that show no apparent correlation between cost and returns, the lowest cost option (index funds) is still going to be the most mindful choice.

Wider evidence also clearly shows that the same conclusion applies to the entire universe of mutual funds and ETFs.  S&P Dow Jones Indices regularly tracks the ongoing performance of over 500 U.S. funds in their SPIVA Scorecard to see if superior performance “persists” over different periods.  In their latest report, they found that none (zero) of the funds were able to stay in the top quartile of performance over the last five years.  And given that 82% of U.S. funds they examined failed to beat a comparable index, falling out of the top quartile means falling into negative excess returns.

John Bogle knew that “costs matter” because higher costs hobble every fund’s performance over the long-term.  This is true regardless of whether you have a limited set of options or can pick any fund in the world.  While at times it may look like a small subset of fund managers are justifying their higher expenses, careful tracking of fund performance, individually and in aggregate, makes it clear that any superior performance is a temporary aberration.

Finally, the comparisons I made here between index funds and similar (not identical) active funds are somewhat apples-to-oranges.  Ideally, funds are compared to other funds that share the exact same benchmark.  A few professionals have criticized me in the past for making these more generic comparisons between funds.  But here’s the problem, rarely if ever will any 401K plan give you the option of an index fund and active fund that attempt to do exactly the same thing.  My comparisons accurately reflect the real-world choices available to the 401K investor.  Of course, the SPIVA results show that even if you have every choice in the world, low-cost index funds are still the best option, regardless of the merits of my analysis here.

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1 – I officially retired a couple of years ago, but I’m still invested in my former company’s 401K plan.  I occasionally do an hour or two of billable work for my company and the 401K provider uses that as an excuse to hold onto my money.

2 – The expense ratio does not include additional costs associated with the operation of the 401K plan itself.  In my statement, operation costs are described with a page of confusing, jargon-filled text.

3 – Five years seemed like a reasonable timeframe given that barely 10 years of data exist for some of these funds.