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Why Cheap Mutual Funds Are Getting Even Cheaper

May 4, 2016, 5:30 PM UTC

Jack Bogle

Founder and retired CEO of the Vanguard group I was a runner for a little brokerage firm here in Philadelphia, delivering securities from one little brokerage firm to another. One of the other runners looked at me and he said, "Bogle, I'm gonna tell you everything you need to know about the investment business." And I said, "What's that, Ray?" And he said, "Nobody knows nuthin'." And it turns out, Ray was right. People say there are great performers out there, but it's a lot of randomness. None of us are smarter than the markets.
Photo: AP Photo

The growing popularity of cheap mutual funds is helping to make them even less expensive. And that’s good news for retirement savers, for whom small decreases in fees can have a dramatic impact on long-term returns.

Last week the asset management firm Vanguard Group reported that expense ratios fell in 2015 for its two largest stock funds, the Vanguard Total Stock Market Index Fund and the Vanguard 500 Index Fund, as well as for the Vanguard Total Bond Market Index Fund and the Vanguard Total Bond Index Fund II. Together, the four funds currently manage $889 billion. Vanguard said that the changes reduced the total amount of expenses paid in 2015 by investors in the funds by $71 million. Overall, expense ratio declines saved investors in Vanguard’s funds $215 million last year.

The declines at Vanguard reflect the growing popularity of the index funds and exchange-traded funds (ETFs) in which it specializes. Those funds’ low fees (along with strong performance compared with more expensive actively managed funds) have been drawing more customers. In general, as mutual funds get larger, their expense ratios drop, as operating costs get spread across more investors.

According to a report published by Morningstar in 2015, U.S. equity index funds account for about 37% of the total market share of mutual-fund assets, up from 26% five years earlier.

Small changes to a fee structure of a fund can dramatically affect the returns of a retirement portfolio. According to research published by Vanguard, an investment of $100,000 would be worth $532,899 after 30 years if the fees were 0.25% a year, but only $438,976 if the fees were 0.9%–assuming the same investment returns for both funds. Put another way, the investment would lose almost a fifth of its value in 30 years if the fees were only 0.65 percentage points higher.

ETFs, which typically have lower fees than mutual funds, have enjoyed several-fold growth in assets over the past decade as investors have sought to reduce the overall cost of their investments. According to the Investment Company Institute, the ETF category had 1,609 funds as of March 2016, an increase of 12% over the prior year.

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Growing competition in the ETF and index-fund worlds is also keeping costs down for consumers. Last November, BlackRock (BLK) cut fees on seven of its ETFs to shore up its leading position in the business. In 2011, BlackRock managed 42% of all ETF assets, while Vanguard, third at the time behind State Street, had 16%. Last year Vanguard managed 23% of ETF assets, second behind BlackRock, with about 39%.

Vanguard founder John Bogle is credited with creating the first index fund. In a 2015 interview with Money, Bogle said, “I never said we have low costs. I’ve said we have low expense ratios. That’s very different.”