Lowest cost index funds are not always the best

Lowest cost index fund fees aren’t always best

Stock index funds are all the rage these days.They occupy about 20% of the global market and this amount is increasing every year. The main driver of the conversion of investors from active to passive stems from the fact that many active funds (after fees) are delivering worse results than passive index funds.

If the majority of active investors are being outperformed by passive investors, this trend we are seeing towards index funds makes perfect sense.

The problem I often see though, is that people are buying index funds based on cost alone.They are repeatedly told that fees matter and it is best to invest with as little fees as possible. While this is not necessarily bad advice, it isn’t great either.

The reason being, we should FIRST decide on how we want to structure our portfolio, THEN look at the lowest fees that meet our ideal portfolio.

If we choose our investment based on low fees alone, then our portfolio is not constructed in a way that we want.

 

An example

Not all index funds are created equally. Some have a cap weighted index where they do not invest more than a certain amount in one company. For example, if Megacorp Inc represents 15% of an index, but the index fund provider has a maximum cap of 5% on any one company, then this index fund will be much more diversified than an index fund that doesn’t implement a weighted cap.  

Imagine in a small country, Like New Zealand, where just 10 oversized companies make up half of the index. An index without a weighted cap will be overly invested in too few companies.Yes, these are the biggest companies, but biggest rarely means best value. The past is no predictor of the future, but it is hard to go past the data that states small cap companies outperform large cap companies.They tend to be better value for money and they have more room to grow. Conversely, they are more likely to fail than higher cap stocks due to their higher risk.

Just by one small detail in whether an index fund provider invests with a weighted cap style or not, can greatly affect the make up of your portfolio. You may be taking on more risk than you wanted. You may not be as diversified as you wanted. All because you made the decision of what to invest based on lowest cost alone.

 

Final Thoughts

At the end of the day, there is not a significant difference between different index funds, but there is enough of a difference to make an impact on your fund performance. Just a 0.3% difference in returns can make a difference over the long term.

Investor A and B both like index funds and invest $10,000 a year for 30 years. Investor A’s index fund is structured slightly different to investor B. Investor A is invested in the cheapest index funds in the market.The fund manager is socially responsible and doesn’t invest in certain companies such as casino’s, weaponry and tobacco. Investor A didn’t know about these exclusions because all he was interested in was lowest fees. Investor B’s funds do not make such exclusions.  

Investor A’s fund returned 6% after fees of 0.4%. Investor B’s fund returned 6.3% after fees of 0.5%. Not much of a difference right?

Investor A has $841,000. Investor B has $891,000. Just a 0.3% difference in performance resulting in $50,000 more for investor B because they were invested in a more diversified index fund, despite the fact their fund cost 0.1% extra. Would you rather have $50,000 more in the hand? 

This is not a real scenario, but it could easily happen.The point of this article is to demonstrate that although fees are extremely important, the most important factor when choosing investments is to first construct a portfolio that suits your goals and risk profile. Do not forget this part of the investing equation. Only then should you focus on fees and shop around. Portfolio construction is more important than fees, but don't let that diminish the importance of fees. 

 

 

The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here.