Cost Efficiency of Index Funds

Actively Managed Funds have a professional fund manager making all the calls on trades. The investors pay the manager's salary through a percentage of the invested assets each year. This percentage is called the expense ratio. The expense ratio is made up of management and administrative costs.

The expense ratio differs dramatically between actively managed funds and index funds. For instance, the average expense ratio for actively managed funds is about 1.5%, while the average expense ratio for index funds is approximately 0.25%. That means investors in actively managed funds are paying on average 6 times more in expenses than they are for index funds. That is a high price to pay considering index funds outperform 85% of actively managed funds over many years.

These expenses eat away a large chunk of investors’ money over long periods of time. This especially hurts the investor when the expense ratio doesn't correlate with the performance of the fund.

To help fully comprehend the consequences of investing in high cost mutual funds, here is an example of how much it would cost to hold versus a low cost index fund.

Lets assume both funds earned average annual returns of 11% (11% is the average annual return of the S&P 500 index over the past 30 years) per year for 20 years with an initial investment of $10,000. Assuming the actively managed fund had an expense ratio of 1.5% (active fund average); the holding cost over the 20 year period would have been $21,032. Therefore, after 20 years your investment would be equal to $59,591.

On the other hand, assuming the index fund had an expense ratio of 0.25% (index fund average); the holding cost would have been only $3,937. Therefore, after 20 years your investment would be equal to $76,686.

Now that is a huge difference! In addition, factor in the tax efficiency and the long term superior performance of index funds and you've got a NO BRAINER!!