What makes an investment fund cheap to own? Low fund fees, of course. But investors completely misunderstand what “low” means, charges Vanguard Group founder John Bogle.
The problem comes with using percentages, specifically percentage expense ratios, to gauge the value of a fund relative to its cost of doing business.
Consider something you buy every week, such as gasoline. If you have a small car, you might buy 12 gallons of regular to fill up. Assume the gas station owner is expecting a small profit on each gallon sold, about 1% of the sale.
If gas is $2 and you fill the tank, your bill is $24 and the station owner gets 24 cents. Simple math.
A big SUV drives up to the next pump. Its tank holds twice as much gas and takes premium, at $2.50 a gallon. Now the gasoline total is $60 and the station owner gets 60 cents.
But hold on, the underground tanks holding the gasoline are no different. The dispensing mechanism is the same. What’s so different that the station owner should expect a 150% bump upward in “expense” to deliver a liquid commodity? The pump runs twice as long, but so what?
Now apply that to the enormous differences between small investment funds and very large investment funds. A small mutual fund might manage $1 billion, while big ones manage tens of billions.
All things being equal, the cost of managing money doesn’t increase along with size. Sure, they might hire a few extra analysts, maybe open a West Cost office. But that doesn’t cost hundreds of millions of dollars to accomplish. Not even close.
Fund expense ratios should drop when funds get larger, Bogle maintains — and they simply haven’t. “This industry’s been born on calculating percentage fees based on the largest denominator it can find, which is a fund’s total assets,” Bogle said in a recent interview. “When you look at the dollar amount, it could easily offend the conscience of the community.”
The Dodge & Cox Stock Fund, for instance, manages $53.7 billion, according to Morningstar, and charges 0.52%. That means the fund collects $279 million a year in fees. If a small investor invests $100,000 from a retirement IRA, the cost to that individual for that one fund is $532 a year.
Comparatively, the Vanguard Stock Market Index Fund ETF charges the same investor $51 a year. Ten times less money!
When money managers attempt to woo new clients they often use “break points” to entice big fish to leave one firm and come to another. Bring us $500,000 and we’ll give you a discount, they say. Often, this means a decline in cost on the next half-million from 1% to 0.80%, then maybe 0.50% on the next million.
Yet they still charge a full 1% on the first $500,000. Then they create a portfolio using those same costly active mutual funds about which Bogle complains. It’s fees upon fees.
Fees reconsidered
All in, even wealthy investors lose their shirts. Fund fees are excessive in dollar terms and show little sign of letting up, even when the funds get huge and have no reason to stay expensive other than pure profit motive.
Change is afoot. We’ve noticed at my own firm, Rebalance, that the cost of using index-style ETFs has been dropping. But even that decline is nowhere near enough to reflect the actual decline implied by the massive increase in assets now held by index-driven funds.
Meanwhile, a host of low-cost advisory models has sprung up, most of them taking the position that the low-price deal offered only to that second $1 million under management should be offered right away and at a much lower entry point, well below $500,000.
How low is low enough on fees? If you believe in efficiency and value, they have been too high for far too long.
