Last week, I climbed a series of stone steps up a mountain. A deep ravine was on my left. On my right, Jordanian vendors offered Middle Eastern trinkets. “Buy from me,” said a young girl who held some bracelets in her hand. “No thanks,” I replied. “I trust you!” she hollered, as I continued up the path.
That was a weird thing to say. After all, I hadn’t promised anything. It did, however, remind me of something earlier that week.
I was in Amman, the capital city of Jordan. Some teachers at the American Community School had asked me to speak about investing. An investment advisor from Raymond James Financial visits the school every year. He offers actively managed mutual funds. But some of the teachers have learned that index funds are better. They have started to say, “No, please build us portfolios of index funds instead.”
Actively managed funds, however, offer advisors nice commissions. They also pay advisors higher trailer fees. That’s why most financial advisors will say no to index funds.
But this guy was different.
“The advisor said he could buy me index funds,” said one of the teachers. “But the indexes he recommended cost 1.75 percent per year.” Index funds win because they charge lower fees. But even most actively managed funds don’t cost that much. In 2014, Morningstar reported that the average actively managed fund cost 1.25 percent. Many actively managed funds cost much less.
At first, I thought the teacher might be hard of hearing. I had never seen an index fund that cost 1.75 percent.
But the teacher’s hearing might have been fine. A few days later, I received an email from a different teacher at that school. Mark Scharen, a 37 year-old high school technology teacher is originally from Oregon. He had asked the same advisor for a portfolio of index funds. The advisor agreed. He recommended four index funds and one that was actively managed. I fell off a chair when I saw how much they cost.
The cheapest among his recommendations was Nationwide’s S&P 500 Index Class C (GRMCX). Yet it costs a whopping 1.24 percent per year. It’s designed to track the return of the S&P 500. But investors don’t have to pay that much. Fidelity’s S&P 500 Index (FUSEX) contains the exact same stocks. Its pricetag is a modest 0.10 percent per year. Schwab’s S&P 500 Index (SWPPX) does the same thing for just 0.09 percent per year. Vanguard’s S&P 500 index is similarly priced.
Investing in Nationwide’s S&P 500 index (GRMCX) is like trying to run a marathon with a 50 pound backpack. This fee-burdened index has fallen 25 percent behind Vanguard’s S&P 500 Index (VFINX) since 1998.
Nationwide’s Small Cap Value C Fund (NWUCX) was the lone actively managed fund that the advisor recommended. It costs an eye-watering 2.20 percent each year. On average, the five funds that the advisor offered Mark cost 1.51 percent per year.
Low-cost index funds beat most actively managed funds because they charge lower fees. But the advantage disappears if the costs are too high. I used wealthgame.ca to show the longer-term damage of high-cost funds. If the stock market averaged a compound annual return of 8 percent per year, a low-cost index fund would average a compound annual return of about 7.9 percent. But investors in high-cost indexes (such as those recommended by the Raymond James advisor) would only average a compound annual return of about 6.5 percent.
That’s a massive difference.
Funds Track The Same Index But Charge Different Fees
Profit Earned On A $25,000 Lump Sum Invested at 7.9% versus 6.5%
Over 25 years, the low-cost index fund would grow to $146,212. In a high-cost index it would grow to just $98,558. In other words, a charlatan’s fees would snatch $47,654.
This brings me back to the girl I saw along that mountain path. She yelled, “I trust you!” as I walked away. But you can’t trust a financial advisor who buys you high-cost index funds. Walk away instead.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.