Investor Alert

Outside the Box

July 1, 2020, 9:44 a.m. EDT

Why investors who are buying fewer individual stocks are getting better returns

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Many of my articles seem to involve warnings about how “the system” is designed to take advantage of us as investors and take away more of our hard-earned money.

Today I’ve got the opportunity to relay a quite different point of view.

While we should not relax our guard for a moment, as many of the individuals and institutions that make up Wall Street still want to reach deep into our pockets, I see several favorable trends for investors. Here are five:

1. We get to keep more of the gains we make in mutual funds and ETFs. We’re talking about billions of additional dollars that collectively belong to us instead of Wall Street.

The reason: Fund expenses have come down dramatically in the past 20 years. According to a research paper published this month by Morningstar, fund expenses last year were on average only 0.45% in 2019 – compared with 0.87% in 1999.

That meant investors like us saved an estimated $5.8 billion – money that can continue to grow for us, not Wall Street. And that was just in a single year.

Morningstar cited three main reasons for this:

Here’s the evidence that investors are wising up: The cheapest 20% of funds (those with the lowest expense ratios) last year attracted $581 billion in net new money, with 70% of it going into index funds. The other 80% of funds had net outflows of $224 billion.

One other interesting finding: Vanguard funds continue to have the lowest asset-weighted average expense ratio – just 0.09% last year.

A couple more statistics I find interesting: Average fees of actively managed funds dropped by 10%, from 1.2% in 2015 to 1.08% in 2019. For index funds, the drop was 15.3%, from 0.72% in 2015 to 0.61% last year.

Morningstar cited a “fee war” among index fund managers that culminated in the 2018 introduction by Fidelity Investments of “zero-fee” index funds that charge no expenses at all.

All this is vitally important to investors. As the Morningstar report says, fund fees “are a reliable predictor of future returns.”

Here’s what that means: The portfolios in our funds earn whatever they earn. Say it’s 10% in a year. From those earnings, fund managers take out some of that to cover expenses. The less they take out, the more we get to keep.

If fund expenses are 1%, we get to keep only 90% of the portfolio’s gains. If expenses are 0.2%, we keep 98% of our gains.

That is the surest formula that I know for getting better returns. 

Wall Street does not like this trend, because it threatens cushy profits, high pay and lavish perks. Too bad.

2. More investors are getting more predictable (and most likely better) returns by using index funds instead of actively managed ones.

Data in the Morningstar report bears this out, citing “steady flows into the lowest-cost funds,” which of course means index funds.

“The mass migration to lower-cost funds and share classes has been a key driver of falling costs,” Morningstar reported. “Expensive active funds have been the epicenter of outflows. During each of the past six years, the most expensive 80% of active funds has accounted for all of the net outflows across all funds.”

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