Index fund fallacy #2 – index funds are the lowest cost way to invest
This is part 2 of a series of articles examining the idea that index funds are superior investments to a portfolio of individual stocks.
In Part 1 of this series I examined the idea that index funds necessarily deliver better performance than individual stocks. In this article I’ll be examining the idea that index funds are a less expensive way to invest than buying individual stocks.
Before I start the analysis, let me reiterate my stance on index funds – index funds are great. I have a significant portion of my wealth in index funds. I believe index funds are the best investment vehicle for the vast majority of investors. Index funds are an easy “set and forget” investment. They are awesome for new investors or investors who want to regularly invest smallish sums of money. They are an easy way to capture the average return of the market.
Proponents of index funds aren’t content to stop there though. For some reason they feel the need to make additional claims that just aren’t backed up by basic statistics or common sense. I’m writing these articles to refute some of those claims.
Mutual fund fees
First, let’s acknowledge something very important – fees matter. In fact, they matter a lot. I believe that most (or possibly all) of the reason for the underperformance of active funds vs. index funds is due to the higher annual fees in actively managed funds. Mutual fund fees are a constant drag on the performance of your portfolio. The fees for index funds are almost always going to be lower than the fees for actively managed funds, but both types of mutual funds have yearly fees.
Now here’s something really strange that NOBODY talks about – your annual fees for your mutual fund is based on the amount of assets you have invested. This is listed as the “expense ratio” in the prospectus.
If the expense ratio is 1% and you have $100,000 invested in the mutual fund, then you pay 1% of $100,000 = $1,000 in annual fees. If you have $1M invested you will pay 1% of $1M = $10,000 in annual fees.
This is completely ridiculous. There’s no possible way to justify paying 10x in fees for an index fund just because you have 10x invested. Most index funds are managed by computer with little to no human interaction needed. For example, a S&P 500 index fund just buys the 500 largest companies in the US stock market. If you buy $1,000 of a S&P 500 index fund, the $1,000 is split across all 500 companies (weighted by market cap). Buying $100,000 of the same S&P 500 index fund does not require 100x as much work for the company managing the index fund.
The only marginally reasonable argument one could make in defense of the expense ratio is that more dollars invested mean more transaction costs. However, transaction costs are miniscule to begin with (mutual funds pay far lower transaction costs to buy/sell stocks than you or I do), and for most trades, there’s little or no difference in cost when trading 10,000 shares vs. 20,000 shares.
In addition, index funds don’t actually buy/sell stocks every day. They keep a cash cushion of 1-2% of the total size of the mutual fund (so they have quickly pay investors who redeem shares of the mutual fund) and actually buy/sell securities a few times a week. When do they buy and sell stocks they don’t buy stocks on behalf of each individual investor who invested in the mutual fund over the last few days. That is, if 1,000 people bought shares of a S&P 500 index fund over the last 2 days the index fund doesn’t go out and buy make individual purchases of shares of all 500 companies for each of the 1,000 investors – that would be 500,000 transactions. Instead, the index fund will group all the investments together and make a few large purchases of each of the 500 companies.
The reality is that it’s almost impossible to justify having mutual fund fees scale linearly with the size of your investment.
Unfortunately, this linear increase in fees as investment size grows is just one major disadvantage (from a cost perspective) of mutual funds.
The tyranny of annual fees
The other major disadvantage of mutual funds (again, from a cost perspective) is that you pay the expense ratio every single year that you own the mutual fund. Regardless of whether you bought shares of the index fund every day of the year or didn’t make a single buy/sell for a decade, you pay the same expense ratio.
The biggest advantage of mutual funds (again, from a cost perspective) is that there’s no cost to buy/sell shares of a mutual fund. Mutual fund proponents point to the lack of transaction costs as the reason that mutual funds are “cheaper” than building your own portfolio.
But here’s the thing – transaction fees are a one-time cost. Mutual fund fees are forever (at least for as long as you own the mutual fund). If you buy 500 shares of a mutual fund (actively managed or index) you’ll pay the management fee every year you own it. If you buy 500 shares of Exxon Mobil today you’ll pay a single transaction fee. You can then own those shares for the next 50 years and never pay a single penny in transaction fees, maintenance fees, or any other fee.
I’ve pulled together some examples to clarify how this works. Here are the assumptions used in these examples:
- I am using Vanguard for both mutual funds and as a brokerage in the examples when buying individual stocks. I chose Vanguard because I use them (making it easy to pull the various costs from their website), they have rock-bottom expense ratios for their index funds, and they are a well-known and reputable company.
- For mutual funds we’ll use the ultra-low-cost Vanguard S&P 500 Index Admiral shares. These require a minimum of $10,000 balance and have an expense ration of just .04%/year.
- If investing via individual stocks you make a transaction 2x/month (every paycheck). The idea is that every 2 weeks you’d take some chunk of money and invest in whatever stock you think is compelling at that time. This is a total of 24 trades/year. Vanguard charges $7/trade.
- You get a 8% annual return on your investments
- We will look at 10-year periods in the examples below
Example 1
In this example we’ll assume you’re just starting your investing career but are dedicated to building your net worth and achieving financial independence as soon as possible. Your initial balance is $0 but you plan on saving $500 from every paycheck ($12,000/year).
Result: Mutual funds fees were significantly lower than the transaction costs from individual stocks.
Example 2
In this example we’ll assume you’re a bit further along in your career. You’ve accumulated $250,000 in investments and you’re now able to save $1,000 from each paycheck ($24,000/year).
Result: Mutual funds fees were slightly higher than the transaction costs from individual stocks.
Example 3
In this example we’ll assume you’re had quite a bit of success in both your job and your career. You’ve accumulated $500,000 in investments and you’re now able to save $36,000/year.
Result: Mutual funds fees were significantly higher than the transaction costs from individual stocks.
The crossover point
If you look at example 2 you’ll see that sometime between years 4 and 5 the mutual fund annual fee becomes more expensive than the transaction costs of buying individual stocks.
It’s pretty easy to calculate the exact value of your investment where this crossover occurs. The costs are equal when:
Mutual fund annual fees = Annual transaction costs for buying individual stocks
We can calculate these values as:
(Mutual fund annual fee) * (value of portfolio) = (number of transactions per year) * (cost per transaction)
Using our assumptions from above:
(.0004)*( value of portfolio) = (24) * (7)
Solving for (value of portfolio):
(value of portfolio) = 24*7/.0004 = $420,000
So, using these assumptions, when your portfolio size passes $420,000 it’s cheaper to invest using individual stocks. At less than $420,000 it’s cheaper to invest via the mutual fund.
You can find the crossover point for your particular set of circumstances by just plugging in the values for your mutual fund annual fees, number of expected transactions, and cost per transaction into the formula above. However, I believe the numbers I used are conservative and reasonable for most people. The Vanguard S&P 500 index Admiral shares index fund is one of the lowest cost index funds I could find. Other index funds (such as small-cap or international index funds) have significantly higher annual costs (which would make the crossover point lower than $420,000).
Most investors don’t have $420,000. As a result, most investors will find it cheaper to invest in index funds than to invest in individual stocks. However, as the size of your portfolio grows the cost advantages of owning individual stocks grows as well.
However, this analysis all assumes that you’re making regular annual purchases of stocks. The fewer the transactions the lower the total investment size needed before individual stocks are less expensive than mutual funds. Here’s an example of making a single $10,000 investment in either an individual stock or a mutual fund.
In this case the mutual fund is 26x more expensive over 30 years than the single stock investment.
Conclusion
As I stated at the beginning of this article, index funds are great, and for many people they are the least expensive way of investing in the stock market. However, once you get to a certain sized portfolio you’ll find that owning individual stocks is less expensive than owning mutual funds. The point at which investing in individual stocks is cheaper depends on your mutual fund annual fee, the number of transactions per year, and the cost per transaction.
Just for fun I ran the numbers with a $10M initial investment, no annual contributions, and 24 transactions/year at $7/transaction. Total fees over 10 years:
- Mutual fund – $57,946
- Individual stocks – $1,680
Longer periods of time and higher investment values will increase the cost advantage of investing in individual stocks vs mutual funds.
The next post in this series will analyze the another frequently touted advantage of index funds – diversification.
Has this analysis changed the way you think about the cost advantages of stocks vs. mutual funds?