Fidelity Investments has been advertising that some of its index funds have fees that are 0.005 percentage points lower than comparable Vanguard funds.
No, that 0.005 is not a typo. Fund families are now competing at the level of thousandths of a percentage point on index fund expense ratios.
This is obviously great news, because it means mutual fund investors can gain exposure to major market indices at a very low cost.
But investors still need to remain vigilant in assessing marketing pitches and fund fees, because not all index funds have expense ratios as low as the 0.045% on the Fidelity 500 Index Premium (FUSVX) or the 0.05% on the Vanguard 500 Index Admiral (VFIAX - Get Report) .
Take, for example, the Rydex S&P 500 Funds listed below, which seek investment returns that match the performance of the S&P 500 index. (After each fund is its expense ratio.)
To be fair to Rydex, it says those funds will match the performance of the S&P 500 "before fees," but how can they come close after fees?
The Rydex mutual fund fact sheet shows that its lowest-expense S&P 500 fund has underperformed the index by an annual average of 2.02 percentage points over the past 10 years.
By comparison, the Vanguard S&P 500 Index Admiral had an average annual return that was was only 0.01 percentage points lower than the index after fees.
An index fund that underperforms its index significantly after fees is worse for your portfolio than you might think. That's because fund companies often list only annualized returns, not compounded cumulative returns.
When you start compounding returns, it can have a significant effect on your portfolio over the years. And when you're saving for retirement, you're saving over decades.
To highlight this point, let's look at total returns using Morningstar data, which account for expense ratios. If you had invested $10,000 in the Rydex S&P 500 Class A index fund 10 years ago, you'd have $17,108.23 now. If you had invested the same $10,000 in the Fidelity 500 Index Premium, you'd have $19,599.17 now. That's a considerable difference! Your nest egg would be more than 14% larger if you'd chosen the Fidelity fund.
I could go on and on about the need for more transparency in the financial services industry, the need for great investor education delivered by independent educators without conflicts of interest, or the high sales incentives attached to some funds.
I will keep this relatively short, though, because, as with index funds, less is often more. The bottom line is that you shouldn't assume that all index funds have low expense ratios, or that you don't have to do your homework (the way you would with stocks) before investing your hard-earned dollars in them.
Ask a lot questions related to all fees and options before making any type of investment. Remember: Caveat emptor!