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?
As a card carrying member of the individual stock picking club, I applaud this series of posts, and deeply appreciate someone presenting an alternative narrative to the indexing kool-aid.
This point (that indexing is not necessarily the lowest cost investment choice) deserves a lot more discussion than it gets.
With that said, I have to quibble slightly with the particulars of your comparison, mainly because the individual stock picking scenario assumes ZERO turnover of the portfolio.
The components of a mutual fund’s holdings change over time, either because the fund manager likes one stock more than another or because the people coming up with the index decide to include one stock over another (this is your friendly reminder that there is NO SUCH THING as truly *passive* investing…someone has to pick the stocks that go in the index).
Outsourcing the decision of what to include or not include in a portfolio is a key benefit of holding mutual funds. Someone holding a DJIA Index fund won’t notice when GE gets replaced by whatever the powers that be choose to put in the index instead. But an investor who has purchased GE shares has to explicitly decide to keep or remove them from their portfolio. Eastman Kodak is another classic example of a former blue-chip fallen from grace.
As folksy and quaint as it may be to say things like, “our favorite holding period is forever”, sometimes you just have to sell some stocks. It’s inevitable.
In other words, limiting trade activity to 2 buys/month in perpetuity is probably not enough. I think that is a good assumption for deploying the new capital as it is invested, but there should be some amount of turnover taken into account as well.
According to Morningstar, VFIAX has 3% turnover. http://portfolios.morningstar.com/fund/holdings?t=VFIAX®ion=usa&culture=en-US
If the individual stock portfolio is designed to hold 100 different companies, you could change out 3 per year and maintain a similar amount of turnover to the index. That would add $42 in annual costs ($7/trade x 6 trades: sell 3 stocks and buy 3 as replacements) to the scenario. This increases the crossover point another $100K or so, but it is a much more reasonable set of assumptions and a better comparison over all (IMHO of course).
Thanks for taking this topic on.
Thanks for the reply. I’ll respond to your last point first – I don’t think it’s reasonable (or even possible) for an individual investor to own and properly manage investments in 100 different companies. In addition, the 2 transactions per month could be used to buy stocks or sell stocks. So if you make 20 purchases and sell 4 stocks in a year you’d have the same number of transactions as in my analysis.
That said, your analysis is reasonable too. However, I’d like to reiterate that the crossover point of $420,000 assumes the absolute lowest possible expense ratio (from the Vanguard S&P 500 Index Admiral Shares). If you had Vanguard Small Cap Index Admiral shares you’d have a .06% expense ratio, which would lower the crossover point to $280,000. And if you wanted some international exposure you might use the Vanguard Total World Stock Index Fund (there appear to be only investor and not the lower cost Admiral shares available for this fund). In this case you’d have an expense ratio of .19%, which lowers the crossover point to $88,421.
To make the expense comparison between index funds and stocks more accurate we’d need to use the weighted average of expense ratios for a few different index funds (maybe total US stock market and a non-US global market) to get the total yearly cost of an index fund. We’d then add a few additional transactions per year to account for selling some stocks, and I expect the crossover point would be somewhere around the $420,000 I calculated in the article.
Part 4 in this series will specifically address the turnover in index funds and address the claim that index funds are the best tax advantaged way to invest.
interesting post. one thing that I get from this discussion is that you are also getting value from the management of the index fund, in other words, the burden of keeping up with what your stocks are doing is significant, and therefore you buy some piece of mind by offloading that to the index fund. That’s worth another $100k or so maybe.
That’s a valid point, and frankly the best argument for buying an index – it requires no research or thought. You just buy the index and do something else. For people who aren’t interested in investing this is great.
Of course, as you build a larger and larger portfolio you’re paying more and more for this management, and at some point you’ll be better off just building your own index at a lower cost.
Your analysis is the first I’ve read to address this issue. I hold a large amount of individual stocks (bought long ago when no one talked of index funds) and have too much capital gains to sell indiscriminately. In the last five years or so, as I read more about index funds, most new investing went to index funds. Your work has inspired me to take another look at returns and costs. Maybe that was not such a poor decision that I made many years ago as a new, young investor to buy all these stocks.
Here’s the reality – brokers make very little money executing stock transactions for you. They make a lot more money when you buy their mutual funds (index or actively managed). That is why you see very little marketing on buying and holding individual stocks, but lots and lots (and lots) of marketing about mutual funds.
Brokers DO make a lot of money providing advice and/or convincing you to buy the stocks or bonds they are trying to sell, but that’s a different matter than a self-directed investor just using a broker to execute transactions.
I’m very pro index funds, but like to hear the other side as well.
A good article, but there are a few important items it didn’t cover. Like risk and diversification. Buying an index fund is much more diverse than individual stocks. You may save money with individual stocks, but end up with a very high risk portfolio.
Not sure how it works in the US, but in the UK you need to pay a broker to hold your shares, which is an ongoing fee.
In the US there’s no yearly fee to hold your shares. If you’re worried about paying the yearly fee in the UK you can just have your actual share certificate sent to you. You can throw those in a safe at home and there will be no yearly fee. Your dividends will get mailed to you as an actual check that you can take to the bank and cash/deposit.
I’ll be addressing the diversification issue in part 3 of this series.
Quite honestly, I like individual stocks because I feel more in control and it is ‘fun’ to me. That being said, thank you for the post. Now I don’t have to feel so guilty about not just stuffing an index fund. I knew there was a reason, I was just too lazy to do the math.
I’m glad I could help!
I’m normally an indexer and haven’t given much thought to the already low fees, but I can see how they could add up over long periods of time and with larger sums. Wondering if you have looked into M1 Finance. I have no experience with them but they seems to allow you to build a portfolio with many stocks or etfs with no fees (no transaction fees and no management fees). They will rebalance for you as well. Would that be the way to go if you decide to invest in a high numbers of stocks?
I haven’t looked into M1 Finance in particular, but I’ve previously looked at Motif, which I think does much the same thing – it allows you to buy a basket of 30 stocks for a single price. I’d have to do the math, but I think this would be roughly as cheap as buying individual stocks. I think the real key is to minimize or eliminate ongoing fees (as much as possible). I think the major advantage of Motif (or something similar) is that it provides easy diversification. The disadvantage is that you have to buy all 30 stocks at once, so it doesn’t allow you to strategically buy a stock that you think is especially cheap.
“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.”
I think it’s great that you have this little blog thing going for yourself. The problem is, individual investors read it and believe the ill conceived advice you, a non professional, gives. Unfortunately for you financial experts like myself also stumbled upon your blog. There is a mountain of available evidence which proves the superiority of index funds. When you state things like you did in the quote above, you just come across as ignorant of the research. I urge you to study the academic research before you make such preposterously false claims such as that statistical research does not back up indexing. They apparently forgot to teach me that when I was getting my MBA, or PhD from the best finance school in the world, nor did they teach me about your statistical methods when I was actually working on Wall Street. You invest in single stocks because you like it better, and that’s fine, but just say that. Don’t make wildly false claims about the effectiveness of index funds. Nearly five centuries of academic research in mathematics, economics, and finance, stand against you.
Well, I actually AM a professional advisor. I’ve passed the Certified Financial Planner exam, I’ve passed the Series 65 exam, and I’m now advising clients.
I appreciate your response, but you have not refuted any of my specific points.
I think my point was pretty clear – index funds are great, but they aren’t perfect, and some of the claims about index funds just don’t make sense. Surely you can agree that a product can be great for a lot of people and still have flaws, right? And surely you can also agree that, no matter how great a product is, there are people who will make claims about that product that aren’t true. And surely you’re not saying that index funds are the only appropriate investment for everybody, right?
Eating vegetables is great. Every dietician in the world agrees that eating vegetables is good for you and should be the cornerstone of a healthy diet. But if somebody claims that eating broccoli is going to cure cancer I think it’s reasonable to point out that, in fact, broccoli doesn’t cure cancer. That doesn’t make broccoli bad. That doesn’t mean nobody should eat broccoli. It just means somebody has said something about broccoli that’s not true.
Similarly, it’s completely true that index funds can cost more to buy and own than a collection of individual stocks. It’s also true that you don’t need an index fund to have a properly diversified portfolio. Finally, it’s true that, mathematically, it can’t be true that most investments underperform the average (an index fund).
I’m curious why these facts have you so upset.