If my understanding of expense ratios is correct, then why do so many people invest with Vanguard?
Is the net annual returns of an index fund calculated as its annual return minus the fund's expense ratio? If so, isn't it better to invest in a fund with higher returns and a comparatively higher expense ratio than Vanguard's?
Yes, the net return of a fund is the fund’s periodic return minus expenses.
If it were possible to know what every fund’s periodic return would be in advance, then, ideally, everyone would want to invest in the fund that will achieve the highest net return. With this foreknowledge, it might turn out that the fund with the highest net return also has the highest expense ratio. So, if the fund has the highest net return, who cares how high the expense ratio is, right?
The difficulty arises because we don’t know how any fund is going to perform in the future. It is not uncommon to see a previous period’s best performing fund turn into a severe underperformer, on a relative basis, the very next period. This is, in part, why the disclaimer “Past performance is not an indicator of future results” is ever present in the investment world.
While we don’t know what a fund’s performance is going to be from period to period, we do know in advance what its expense ratio will be. When we compare the fixed cost associated with an expense ratio to the variable returns of a fund, we have to decide if the uncertain expectation of higher returns is worth the built-in loss attributed to expenses when evaluating a fund that has a comparatively higher expense ratio.
So, in my opinion, you’re right to believe that cost is not everything. Why would anyone invest in a fund that consistently underperforms its peers and/or benchmark on a net basis just because the expenses are low?
However, depending on the fund(s) in question, there are many good arguments for building portfolios that utilize low cost index funds to achieve the core risk and return exposure desired, and only using more specialized and higher cost funds to fill in the gaps. The thought with this, pure indexing, and other passive investment focused strategies, is that expenses represent a negative return known in advance. The higher the expenses, the greater the drag on investment returns over time.
With so few funds able to consistently outperform their benchmark, for many investors, it makes more sense to accept benchmark-like returns at a lower cost, than to hope for better periodic performance with higher fixed costs known in advance. That being said, although an extremely important factor, cost shouldn’t be the only consideration when evaluating a potential investment.
Vanguard's funds are passively managed. The holdings in each of their funds are intended to match the constituency of different market indexes. Since there are no portfolio managers involved, that expense is eliminated, which helps Vanguard keeps its fees among the lowest in the fund industry. With that said, the net annual returns stated are after the fund's expenses are deducted.
Although there are times when other funds may have higher returns, the reality is that over time the net returns on passive funds such as Vanguard's are usually higher since the added cost of active portolio management is not offset by higher net returns.
Folks are drawn to Vanguard since the net returns of their funds tend to be higher than the net returns of actively managed funds.
Actively-managed funds are normally paired up with an index/benchmark to compare performance. Only about 20% of managed funds beat their benchmark. Because of that statistic, many investors choose to stick to a low-cost fund that just follows the benchmark instead.
A recommendation I have for the ones looking for outperformance in active management, is to look at the size of the fund. Managers have a hard time finding opportunities when the their fund becomes very large. They have to spread their portfolio across more positions to avoid moving the market when they make a change in their allocation. When this happens, the fund will start to look more and more like the benchmark. Find a fund company that has a history of closing their funds to avoid this problem.
I hope this helps.
If a fund's higher returns are due to its management's skill then a highter fee may be justified.
If you are just investing passively in say the S&P 500 index then the lowest cost index fund would be the best option.
I prefer stocks of value creating companies over funds. Many funds underperform their benchmarks.