Data Source: Morningstar, Inc.
The study found that as a whole, the most expensive funds significantly underperformed the least expensive funds. The underperformance of the expensive funds was found true for every asset group and for every time period studied. Looking at the graph, it is particularly interesting to note the consistency of the investment return performance gap between high-cost and low-cost funds, regardless of the asset category. It is also interesting to note that for each of the fund categories, the difference in average returns is roughly equal to the difference in average expense ratios.
These expenses investors pay account for much of the historical investor underperformance compared to market indexes. In John Bogle’s Little Book of Common Sense Investing, he compared the twenty year period from 1983 to 2003, a period covering the great bull market of the U.S. stock market during the 1980s and 1990s. Bogle found that the return of the 600 U.S. stock mutual funds in existence during the entire period earned an average of 10.3% per year. That average was 2.7% below the U.S. stock market’s average (based on the S&P 500 index), which earned an average of 13.0% per year.
Unfortunately, that’s not the whole story. Because of the general tendency for investors to buy at higher prices and sell at lower ones, the average return for the investors in the funds during this period was even lower, averaging just 7.9% per year. This would have reduced the increase for the average investor to a little over four times over this period, compared to more than 11 times for the market as a whole.
Similarly, in a Dalbar, Inc. study of the period from 1988 to 2008, a period of lower returns, the average investor in stock mutual funds earned an average of just 1.9% per year, while the stock market earned an average of 8.4% per year. The average bond fund investor over the same period earned an average of just 0.8% per year, compared to a benchmark bond market index, which earned an average of 7.4% per year. Below I've compared some market benchmarks to investor and fund returns over comparable periods.
Sources: Dalbar, Inc., John Bogle, Ilia Dichev
In these analysis’ we see two primary culprits to the general underperformance of investors underperforming the market. The first is bad market timing, the inclination to buy those investments that have risen the most and to sell investments after sharp declines.
The other major obstacle to investor obtaining adequate returns in managed investments such as mutual funds, are the expenses investors pay. In my last message I mentioned that the average actively-managed stock mutual fund expense ratio approaches 1.5%. In addition to these stated yearly expense ratios, all funds have trading costs that come out of shareholder returns. These trading costs can add up to another 0.5%, 1.0% or more with highly active, high turnover funds. Adding these expenses, we can easily see how average stock fund expenses can exceed 2.0% per year. The level of these yearly mutual fund expenses is similar to the performance gap in the 20-year Bogle study looked at above. That analysis found that the average stock mutual fund returned an average of 2.7% less per year than the market. Over this long time period and large sample size that included every stock mutual fund in existence over the entire period, we see that the performance gap between market and funds was closely related to the average expenses incurred by the funds.
In investing, expenses do matter. Whether it’s the fees and commissions mutual fund investors pay, the trading costs to buy and sell individual stocks, asset management fees or advisory fees, they matter. One of the major obstacles that investors face, often without realizing it, is the fees that they pay. Investors who know how much they’re paying for all of their investments, and work to contain those fees, are going to have a much greater chance of investing and financial success.
In a book I recently published, Let Your Money Grow, I talk more about some of these factors responsible for investing success.