Regardless of how well or poorly your chosen area of the stock or bond markets perform, when investing in ETFs or mutual funds, you can come out with more if less in fees are being deducted from your investment. But few investors likely have a sense of exactly how costly fund investment fees can be to the long-term investor. If, for example, your funds’ expenses average 1% a year, and you have $50,000 invested altogether, you are paying $500 each year out of your accounts to own these funds. Over longer periods, the payment of these fees mean that the amount lost to fees grows greater since each $500 would keep compounding if it had remained in your account.

In this article, I will discuss not only the huge effect fees can have on success as an investor, but also the potential importance of hitching your wagon to an ETF or fund that can potentially outperform even after fees are taken into consideration.

Are ETFs the Answer?

In recent years, there has been a tremendous amount written about why mutual funds are no longer considered to be attractive while ETFs (Exchange Traded Funds) are. But are ETFs really always better than traditional mutual funds as is frequently implied? I have devised guidelines for whether, looking forward, it no longer pays to buy mutual funds but rather ETFs instead, and if one already has funds, whether to move them to ETFs.

I wish there were simple answers. But as you will see, there aren’t. However, there are some rules of thumb you can use to determine whether you should continue to hold any mutual funds or whether you should consider looking for and switching to comparable ETFs, since one of the main claims made for ETFs is the notion that ETFs are almost always lower in cost. If true, other things being equal, lower costs should mean higher returns since you get to keep more of what the underlying investments earn.

But, in reality, another possibility is merely trying to find and possibly switch to comparable mutual funds with costs as low or maybe even lower than some ETFs; surprisingly, some do exist. Of course, all of this assumes you do have the possibility of switching into comparable low cost options since perhaps your choices are restricted, such as within many 401(k) plans.

Honestly speaking, in recent years there has been a tremendous amount of hype surrounding ETFs. For example, here is what I found on a website that is obviously geared toward pitching to the ETF investor: For all the benefits exchange traded funds (ETFs) offer, it’s little shock that they’re trouncing mutual funds in nearly every regard. Such a statement shows not only the writer’s bias, but ignorance as well. In reality, there is often very little or no bottom line advantage for owning many ETFs over comparable mutual funds.

The largest ETF, the SPDR S&P 500 ETF (SPY ), has returned 5.2% over the last 10 years (through 6-30-12). But so has the very low cost Vanguard 500 Index Fund (MUTF:VFINX ). So where was the advantage?

Since many index funds often (but not always) wind up doing better than managed funds of the same fund category, then perhaps the whole spectrum of index funds should be higher within investors’ priorities vs. comparable managed funds. But when low cost index funds are matched head-to-head with similar ETFs, one can find little evidence of the performance superiority of the latter. And, even when costs are lower, are they really significantly lower enough to justify switching out one’s mutual funds to such lower cost options?

Expense Ratios

The average actively managed fund has an expense ratio of about 1.3% while it’s 0.85% for the average index fund, although it is not hard to find index funds that are much lower through the biggest players such as Vanguard or Fidelity. If you are paying anywhere near these averages, then by comparison, ETFs could definitely be worth switching to, as the average expense ratio of an ETF is 0.55%. But, in fact, many index funds these days are available with the same (or nearly so) low cost as comparable ETFs. So, if you own such extremely low cost index funds, or even in some cases low cost managed funds, cost can be virtually a non-issue.

In practical terms, expense ratio is the cost to you every year to own a fund. It goes mainly to pay the fund company and its employees for the services it is providing. For example, if your stock fund has an expense ratio of 1.00%, this means that if the fund’s investments actually earn 8% during a given year, your total return will be reported as 7%; the 1% is deducted from your return gradually during the year so you won’t ever notice it. (Any sales charge, or load is a separate amount and is not included in the expense ratio. You should avoid all such load funds whenever possible.) You can readily discover what a fund’s or ETF’s expense ratio is on many websites, such as morningstar.com.

Sometimes, to get the lowest expense ratio, it may be necessary to have invested a greater amount than the minimum to open an account. Vanguard index funds require you to have a minimum of $10,000 to acquire an equivalent, but lower cost class version of their index funds. For example, the expense ratio for an account less than that amount in their S&P 500 fund, the so-called Investor class (VFINX ), is 0.17 which means that for every $1000 in the account, it will cost you $1.70 per year. But the lower cost Admiral class (MUTF:VFIAX ) will only cost $0.05, or $0.50 per year per $1,000.

Now back to the assumed superiority of ETFs, and guess what? The cost of the Vanguard S&P 500 ETF (VOO ) is exactly the same as for the Admiral class mutual fund. Thus, if you already have VFIAX, then there would be no apparent reason to switch to the equivalent ETF.

The real issues in comparing any two funds, then, are a) can you find an equivalent fund or ETF with lower costs, and, if so, b) if the cost is only different by a small amount, say the 0.12 difference between VFINX and VOO, is making the switch really worth the effort?

Making the Comparisons

According to Vanguard’s website, if you invest the minimum $3,000 allowed to open a VFINX account, and the return you expect to receive is 7% annualized over the next 10 years, your total cost will be only $72 over the entire 10 year period. If, on the other hand, you open the Vanguard S&P 500 ETF with the same $3,000, your cost will be $22, or a savings of $50. That comes to only a $5 a year difference! That may be hardly worth taking the time to make the change. (The example assumes you are making the exchange commission-free at Vanguard’s brokerage; other brokerages may charge a commission. It should also be noted that in this example, you can convert from shares in VFINX to VOO without being considered to have sold the investment which would entail either a capital gain or loss. If you are performing a similar switch at another brokerage, you should check as to if this would be considered a sale or a conversion.)

But perhaps you own one or more managed funds and are trying to decide whether to keep each such fund or switch to an another fund of the same category that may have a more significant savings as compared to the expense ratio you now pay.

Stock Fund Examples

In the following examples, assume that your initial investment in a fund is $10,000, you do not make any additional purchases or sales over a 10 year period, and returns are hypothetically projected using a financial calculator.

-You own Fidelity Contrafund (MUTF:FCNTX ). The expense ratio at .81 is below that of the average managed fund, but still a little cumbersome. What if, instead, you choose another similar, but managed fund or ETF with a lower expense ratio of 0.45.

If the underlying portfolio return (i.e. before expenses are deducted) for each average the same 7.0% annually, the savings by switching to the lower cost fund could eventually be significant. The savings would at first be only $36 after one year. But due to compounding, after 10 years would be $627 in favor of the lower cost fund. The longer you hold the lower cost fund, and if the funds’ return more than the 7% annualized, savings grow exponentially. Thus, the savings grow to $2781 over 20 years if the return averages 8%.

So it might appear that owning a lower cost fund should be nearly always the way to go. But not so fast. Over the last 10 years, Contrafund has outperformed the average fund within its category (Large Growth) by a whopping 8.17% to 4.83% annualized. This means on a 10K investment, FCNTX would have grown to $21,932 vs. $16,027 for the average fund, even assuming the average such managed fund had a more competitive expense ratio of 0.45. Thus, on a 10K investment, FCNTX would have returned $5905 better, or $590 per year over 10 years!

This example shows that a higher cost fund that consistently outperforms another lower cost fund by more than the difference between the two expense ratios will be superior in terms of investment growth. Or, put otherwise, to offset a higher expense ratio, an active fund manager needs to give the investor better returns than the competition to make up for the expense money going out of your pocket to the fund itself.

-But suppose you compare Contra with an index fund or ETF in the same category with an expense ratio of only 0.10, such as Vanguard Growth ETF (VUG ) or Vanguard Growth Admiral (MUTF:VIGAX ). Again assume the pre-fee returns are the same as Contra at 7%. Now the return advantage will be $71 for the lower cost fund in the first year, and $1,256 over 10 years. But, contrary to our assumption, over the last 10 years, Contra has outperformed Vanguard Growth Admiral by 2.15% annually (VUG came on to the scene in 2004). So, as above, a calculator shows Contra would have returned $21,932 vs. $17,942 for a difference of about $4000. This is a significant amount of money, made possible because the Contrafund manager was able to get a lot better performance from his portfolio than the unmanaged index.

Will Contra continue to outperform the index by a significant amount over the next 10 years? If so, one would be much better off owning it. But if Contra’s portfolio fails to beat these low cost index funds, then you be better off in them. (During the last 5 years, there has been virtually no difference between FCNTX, VUG, and VIGAX.)

So in deciding whether to switch from a higher cost, managed mutual fund to a lower cost index fund or ETF, investors should not be fooled into believing that the latter choice will always be superior. The key determinant comes down to whether the manager of the former has shown that he/she does have the ability to do better than a comparable index over extended periods of time. While prior outperformance is not a guarantee of future outperformance, and granted many people do not believe that any manager can consistently outperform based on skill beyond mere spurts of luck, an extended record of outperformance can suggest that more than just luck is responsible.

Comparing Any Two Funds

For those who want a quick summary of how much money can potentially be saved when deciding on what type of fund investment to choose going forward, you can check the following table I have devised. It shows the amounts of loss or gain you would see in the balance of your account when comparing a lower cost fund with a higher cost one for two equally performing funds (i.e. before fees), as well as in instances the more expensive fund is able to significantly outperform the lower cost fund as described in our examples.

Potential Effect on Account Balance When Choosing Funds