I’ve spent the last two days advocating for low-cost index funds.  But what’s the big deal? Does it really matter if an investment costs me another percentage point? 

 Yes, yes it does.

Determining costs through the expense ratio

To determine the costs of owning a mutual fund, you look at its expense ratio. This ratio represents the annual calculation of a fund’s operating expense (management, advertising, administration, etc.) divided by the average dollar value of its assets. This ratio is expressed as a percentage. To find out your costs, you simply multiply that percentage by how much you have invested in the fund.

Expense ratios can vary widely. Vanguard’s 500 Index Fund Investor Share currently has an expense ratio of .17%. Some actively managed funds can be as high was 1.5%. Therefore, if you had 10,000 invested in those funds, you would pay $17 per year invested in the index fund versus $150 dollars in that actively managed fund. You pay these costs from the fund’s assets, and consequently you should subtract that cost when calculating any investment return.

$133 per year seems like a lot, right? You haven’t seen anything yet.

How costs add up over the long run

Say you have two mutual funds that start out with $100,000 and both give a 6% return. However, one fund has a yearly expense ratio of 1% (making the actual return 5%) and one has an expense ratio .25% (providing a return of 5.75%). Over a 30-year time horizon, the fund with the 1% expense ratio increases to $432,194, while the fund with the .25% expenses ratio increases to $535,070. That’s a difference of over $100,000! And that doesn’t take into consideration any additional contributions. That discrepancy grows, the more money that you invest.

I picked those expense ratios randomly to make the math simpler. But that kind of discrepancy between index and actively managed funds exists in the real world.

According to the Investment Company Institute, the average expense ratio for an actively managed equity fund in 2012 was  .92%. The average expenses ratio for an equity index fund was .13%.  So in our $100,000 mutual fund example, the actively managed fund earns $442,183, while the index fund earns $553,589 over that same period. Again, that’s over $100,000. I don’t know about you, but Ben and I would love to use that money to travel in retirement.

Paying more, doesn’t get you more

Some active management enthusiasts might argue that you get what you pay for when it comes to mutual funds. In other words, actively managed funds costs more because they produce better returns. However, countless academic studies and industry research dispute this argument.

According to the most recent SPIVA® report, a Standard and Poor’s bi-annual report that measures the performance of actively managed funds against their relevant index benchmarks, 59.58% of large-cap funds, 68.88% of mid-cap funds and 64.27% of small-cap funds underperformed their respective benchmark indices from June 2012 through June 2013. The results were just as unfavorable over three- and five-year periods.

The bottom line: costs matter. ($100,000!!!!) Make sure you know exactly what an investment costs you and what you get in return.