Hey hey, and welcome back to lesson 3 of The Minimal Investor!
Lesson 2 Review – Diversification
We did a lot inlesson 2. Understanding market sectors, market classes, and fund types is a lot to understand. Here’s a reminder of what lesson 2 covered:
- There are a few different ways of slicing up investments
- Market Sectors – Technology, Health Service, Finance, Consumer Goods, etc
- Market Classes – US Market, International, Bonds
- Fund Types – Stocks, ETFs, Mutual Funds, Bonds
- Diversification means investing a portion in the US, international and bond markets.
Lesson 3 Overview – Fees
In this lesson, we’ll be using this knowledge to look at different funds at your brokerage and understand what they’re investing in. We’re going to start by evaluating funds, then see which parts are the most important. For this lesson and all future lessons, we’ll be focusing entirely on ETFs and Mutual Funds.
I’m going to use the term ETF throughout this course, but these two are effectively the same. We won’t be focusing on individual stocks from here on out due to the amazing diversification advantages of using ETFs that we talked about in lesson 2.
Here’s what we’ll be we’ll be doing in lesson 3:
- What funds does your brokerage offer?
- What does all of this information about a fund mean?
- How do fees affect my portfolio long term?
- How do I choose between the rest?
At the end of this lesson, you should have a solid grasp on exactly which funds are best picks when evaluating them as a minimal investor.
1) What funds does your brokerage offer?
If you have a 401k, let’s start there. Login to your brokerage account (Vanguard, Fidelity, etc) and find the list of funds they offer. If you’re using a general stock trade company like E-trade, you’ll likely be able to invest in anything, but at a fee. If that’s the case, you can buy Vanguard ETFs from there. Head over and find your available funds list and come back.
If you check out the Vanguard list of funds, you’ll see there are 126 funds on this list. That’s a ton of funds! Let’s narrow this down a little. Make sure you’re viewing “Mutual Funds” and listing them by “Asset Class”. These classes should look familiar from lesson 2. Here’s a recap of all the asset classes that Vanguard offers:
- Money Market – This just means cash. These are comparable to a savings account.
- Bond – (Some Type) – Lending money in exchange for more money later. There’s a bunch of different bonds.
- Stock – If it just says “Stock” on Vanguard, that means US Stock Market.
- International – Anywhere outside of the US.
- Balanced – These funds combine multiple classes including bonds, stocks, and international funds.
- Stock – Sector – These correspond to the market sectors from lesson 2 (Energy, Health Care, etc).
These will be familiar from lesson 2! Also from lesson 2, we can eliminate the “balanced” category (we want more control, and fewer fees). We can also eliminate the “Money Market” category. This isn’t generally a tool for investing, but a tool to store your money between trades. Depending on your brokerage, when you make a deposit it may start in a money market account. That’s OK for starters – you can leave it there safe and then exchange it for funds later.
We can also eliminate “Stock – Sector”, since that’s not as diversified as we’d like. That leaves 3 Asset Classes for us to focus on:
Again, we’re back to the Simple Three-Fund Portfolio at Vanguard! These are the 3 groups we keep coming back to.
- Find the list of funds at your brokerage
- See which assets classes the funds in your brokerage are
2) What does all of this information about a fund mean?
Let’s pick out some funds to analyze. In order to filter things out a bit more, let’s focus on only stocks for large companies. Filter the Vanguard Funds List for only funds that meet the following conditions:
- US Stock
- Large Cap only
This will limit what’s shown to only US Stocks that include large-cap companies. It doesn’t mean these funds will only invest in large companies, but that 50% of the money in that fund will be invested in companies above $16 billion.
We’ll take 3 funds from this list and compare them:
- Vanguard 500 Index Fund Admiral Shares (VFIAX)
- Vanguard Diversified Equity Fund (VDEQX)
- Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
Vanguard allows comparing these funds which make it a little easier to see what’s different about each. Let’s take this row by row.
The symbol of a stock is its unique identifier within a market used for buying, getting prices and all that. Whenever you refer to the fund you’re buying you’ll use the symbol.
This is stock for all of these because we filtered for it. Later on, we’ll try filtering for international but this comparison is about the US Stock Market.
Again we already filtered for this, but large blend means the most companies in this fund will companies above ~$16 bln.
This one is new! Risk potential is an indicator of the volatility of the fund. A risk level of 1 means the value will remain mostly the same (like cash), while a 5 means there could be extreme fluctuations in the price – but with potentially more gains. Risk correlates directly with possible reward. The longer your investing timeline, the more risk you can take on.
This is the most important number on the above chart! For Vanguard 500 and Total Market this number is 0.04%, but for the Diversified Equity fund, this is 0.36% — that’s 9x higher! What does this even mean, and why the difference?
Expense ratio means that that much of your investment is used to keep the fund running. You’ll never pay this fee directly, but you’ll be paying it in the form of the value of the stock. Here’s an example:
If you invested $10,000 in VTSAX and by some fluke, the stock stayed even for the year (and didn’t give off any dividends – which we’ll talk about in lesson 8), you’d still have $10,000 in your account. If you invested $10,000 in VDEQX and it stayed even then again you’d have $10,000.
The difference though is that for the value of the stock to stay the same, the underlying assets within VTSAX actually needed to go up 0.04%. That increase wasn’t passed on to you, the stockholder, and instead went to Vanguard to run the fund.
For VDEQX, the underlying assets needed to increase by 0.36% for you to not see a drop in your value!
Active Managed Funds vs Index Funds
The reason that VDEQX has 9x the fees is that it is an actively managed fund. Actively managed funds require actual human input to make the decisions for what’s invested in. This doesn’t mean every decision has a human behind it, but the strategy of the fund is being controlled by a human whose goal it is to beat the market (index funds).
Index funds are tied to a specific market index and will invest in funds to match. For instance, the Vanguard 500 Index Fund tracks the 500 largest funds in the US stock market. Other funds, like the Vanguard Total Market fund, track to an index that Vanguard defines specifically for this fund.
I only invest in Index funds, and wouldn’t consider investing in actively managed funds. Active funds seek to outperform the market, but research shows index investors make 3-4% more per year, pay fewer taxes and experience less volatility. This is the approach Warren Buffet even advises new investors to pursue. I’d encourage you to only invest in index funds and not actively managed funds whenever possible.
The last part of the chart is the Nav (Price) of the fund. To me, this is an ignorable field altogether. The value of an individual share has no impact on anything useful. A higher price or a lower price doesn’t mean the stock is “better”. Likewise, whether the fund has gone up or down doesn’t have any impact on what it’ll do in the future. It’s possible to buy a portion of a share, so there’s no need to worry about the price. If you have $16.42, you can invest just that much in a fund.
Looking at daily change, YTD change (year to date), 1 year, 5 years, 10 years and “since inception” number for a fund it’s not going to be useful in helping you make a decision. Remember from lesson 2 (diversification) funds are going to have up years and down years. It’s less important to be in the fund that performs the highest and more important to be diversified.
- Look over the table of funds and filer them for large-cap blend index funds
- Find which funds are actively managed and exclude those.
- Look at fees charged for funds you have available.
3) How do fees affect my portfolio long term?
Fees are bad, but how bad are they? Let’s look at a scenario and see. Imagine you’ve invested $10,000 in 4 different ways:
- Fund A: $10,000 in an index fund with a 0.04% expense ratio.
- Fund B: $10,000 in an actively managed fund with a 0.50% expense ratio.
- Fund C: $10,000 with an advisor who charges a 1% fee, who invests in a 0.04% index fund, effectively a 1.04% feed.
- Fund D: $10,000 with an advisor who charges a 1% fee, who invests in a 0.50% index fund, effectively a 1.50% feed.
Let’s assume the funds each gain 7% a year. As we learned from (2), that means that the underlying assets of D will need to grow 8.5% (7%+1.5%), while fund A will only need to grow 7.04% (7% + 0.4%). Let’s see how much you would pay in fees over some number of years.
Fees Impact on Investment Growth
|Fund A||Fund B||Fund C||Fund D|
|10 yr value||$19,596||$18,741||$17,780||$16,997|
|10 yr fees||-$76||-$931||-$1,892||-$2,675|
|10 yr fees %||-0.40%||-4.70%||-9.60%||-13.60%|
|20 yr value||$38,398||$35,121||$31,612||$28,889|
|20 yr fees||-$299||-$3,576||-$7,085||-$9,808|
|20 yr fees %||-0.08%||-9.2%||-18.30%||-25.30%|
|30 yr value||$75,244||$65,818||$56,206||$49,101|
|30 yr fees||-$879||-$10,305||-$19,917||-$27,020|
|30 yr fees %||-1.20%||-13.50%||-26.20%||-35.50%|
The amount you’re paying in fees compounds over many years until the point where you’re paying more in fees than you initially invested! It’s possible to invest $10,000 and pay $27,000 in fees over 30 years.
Even the difference between a fund with a fee of 0.04% and a fee of 0.50% is huge over 30 years – enough to justify choosing a cheaper fund for sure.
“But no one invests in those high fee funds, right?”
Right after college, my mom passed away. I inherited $100,000 from her and started trying to learn everything I could about investing to understand what to do with it. I talked to my bank, and they had financial advisors who could help those like me who didn’t know what to do.
The price for this help was a 1% investment advisor fee each year – regardless of how well the fund did. On top of that, some of the funds they invested me in had expense ratios above 1%! Some were even “load funds” – funds that charge a percentage fee when you buy into them (these are the absolute worst – avoid them like the plague).
The end result was me paying upwards of 2.25% in fees. Over 30 years, this would be 50% of my gains going to fees. When I eventually did the math on this I was shocked! Did I really want to pay someone half my potential investment earnings so they could make a few decisions a year? Could I make those decisions instead?
Your Fees Visualized
If you’re already investing and want to understand how much you’re paying in fees now, you could create a spreadsheet and calculate this (the total amount invested * fee percent).
Or if you’re looking for a tool to do it, you can use Personal Capital Retirement Fee Analyzer* and link it to your existing accounts. It will pull down a list of your investments, find out their fee % and provide an overall fee % for your entire account. Here’s a snapshot of what mine looks like from Personal Capital.
Seeing this calculated for me is a nice reminder of how I’m doing compared to other potential investments. I try to keep this as low at it can be while remaining diversified.
- Fees compound and can cost you a lot – maybe even half of your potential investment gains.
- Understanding fees allow you to rule out a bunch of overpriced funds.
4) How do I choose between the rest?
We’ve ruled out a bunch of funds for the following reasons:
- Funds are too specific (market sector)
- Funds are too broad (balanced / target retirement funds)
- Funds with fees that are too high
- Funds that are with an advisor who charges a fee
Even with these reasons ruling a bunch of funds out, there would still be 9 funds to choose between in the US Stock Market category on Vanguard alone:
- 500 Index
- 500 Index Admiral
- Dividend Appreciation Index
- Dividend Appreciation Index Admiral
- Large-Cap Index
- Large Cap Index Admiral
- Total Stock Market Index
- Total Stock Market Index Admiral
- Tax-Managed Capital Appreciation Admiral
We’ll skip the “tax-managed” one for now, but revisit it in lesson 8. For the remaining 8 funds, you’ll notice that 4 say “Admiral” at the end and 4 don’t. Vanguard has a concept of “Admiral” funds and “Investor” funds. Admiral funds hold the exact same underlying assets as Investor funds, but Admiral funds have a lower expense ratio — 50%-75% lower actually!
So why wouldn’t you just always use admiral funds? The reason is that there is a minimum investment. Take the Total Stock Market Index Fund for example. The Admiral version has a minimum investment of $10,000, while the Investor version has a minimum investment of $3,000.
It’s always better to be invested in Admiral shares since it’s cheaper, but don’t let that stop you from investing at all. I started with all of my funds in Investor shares myself. Once you invest enough that you’ve met the minimum, Vanguard will offer you the choice to convert your funds from Investor to Admiral funds.
If we group Admiral and Investor together, we’re down for 4 funds to look at:
- 500 Index
- Dividend Appreciation Index
- Large-Cap Index
- Total Stock Market Index
4 funds from Vanguards 126 – not too bad! The difference between these 4 won’t make a huge difference. If you invested in any of them you’d be in pretty good shape. We can refine a little further to help choose The Fund we’ll invest in within this category by taking into account expense ratio, diversification and market cap for the fund. “Market Cap” just mean how much in total is invested in that fund from all investors. The higher the market cap, the more investors that are choosing that fund to invest in.
Here are the key details for our funds:
|Fund||Expense Ratio||Market Cap|
|500 Index||0.04%||$341 billion|
|Dividend Appreciation Index||0.08%||$30 billion|
|Large-Cap Index||0.06%||$16 billion|
|Total Stock Market Index||0.04%||$603 billion|
From this, we can see that 500 Index and Total Stock Market Index have the lowest expense ratio, but Total Stock Market Index has a market cap that’s far higher. This isn’t a guarantee of success, but at least it means we’ll be in good company. After market, diversification, and fees, the market cap is a good tiebreaker. With that in mind, we can choose Total Stock Market Index for our US Stock fund.
This doesn’t mean it’ll perform the best, or that it’s a sure thing – just that it’s a solid choice. By taking into account fees, market cap and diversification, we’ve narrowed the field down to a few funds – and all of them would likely perform just about the same.
If we did the same for International Funds, there would be a lot more funds to consider, and with harder to understand names. What we want to find is a single fund that invests everywhere outside of the US for a low fee. Because of that we can rule out any funds that invest only in a specific area, have a high fee or only invests in a certain type of international market (like real estate or developed markets only).
If you went through every Vanguard fund with these criteria, you’d find there are 2 funds that meet these conditions:
|Fund||Expense Ratio||Assets||Fund Count|
|Total International Stock Index Admiral||0.11%||$300 billion||6,190|
|Vanguard FTSE All-World ex-US Index Fund Admiral||0.11%||$33 billion||2,600|
The Total International Stock Index Admiral fund looks a lot like the US Stock we picked, but what’s that FTSE All-World ex-US one? These funds are invested in many of the same things, and if you look at their performance over the last 10 years it’s almost identical. With that in mind, we can look at the total number of assets and the number of other funds each is invested in.
With ten times the assets and over twice the number of funds, we can see that more people are choosing Total International Stock Index Admiral and that it’s also more diversified. That’s a good pick for an international fund.
Bonds might be the most confusing of the 3 main categories to choose our best fund. When choosing a bond fund, you can use the same context as before – low expense ratio, a high number of bonds invested in within the fund, high number of assets under the fund.
If you rule out any funds that are government only (that would be a sector of bonds), are international funds, or target a specific time period (short term, long term etc) only a single bond fund meets those requirements: Total Bond Market Index.
This fund invests in government and corporate bonds or varying time periods – short term, long term, intermediate term. It’s really the only bond fund you need.
- Pick index funds with low fees and high diversification.
- Use market cap of a fund as a tiebreaker.
- Look at the number of investments within the fund to understand how diversified it is.
Lesson 3 in Review
We got really in depth in this lesson on how to analyze funds to understand which ones we should choose. The rules for analyzing funds are slightly different for US Stocks, International Stocks, and Bonds – but some concepts are the same for each. Investing in index funds that have low expense ratios is key for all groups.
If you’re not investing at Vanguard, you should be able to use the same principles to find the lowest cost funds at your brokerage. Find the US Stock, International Stock, and Total Bond market fund there and add them to your spreadsheet – we’ll need them in next lesson.
Before we make any investments, we have one more thing to figure out – which brokerage accounts you use to invest in. If we know we’re going to invest in the three funds listed here, how do you split the investments between a 401k, IRA, Roth IRA and a brokerage account? That’s what we’ll be looking at the next lesson when we go over the principles of tax-efficient fund placement.
Do you have any questions on topics from this lesson? Feel free to reply to this lesson, or jump on Slack to chat (this is a new Slack group, so don’t be scared off if it’s just a few other Minimal Investor readers!).