Cutting Small Expenses Can Mean Big Returns

Investors are always searching for something that will correlate with high returns. Typically, they search for a broker or adviser who can pick stocks, time the markets, or recommend the next hot fund manager. Unfortunately, there is no evidence anyone has these skills and abundant data indicates that these strategies don’t work.

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However, there is something that will help investors reach their retirement goals: Low fees. A fund with lower expenses is likely to outperform a comparable fund with higher expenses. Index funds, which simply track a designated benchmark such as the S&P 500 index, generally have lower expense ratios than actively managed funds, where the fund manager attempts to beat the returns of a benchmark.

Since expense ratios are deducted from the returns of a fund, the higher expense ratios of actively managed funds make it very difficult for them to equal the returns of lower expense ratio index funds.

You may be surprised at the bottom line effect higher expense ratios have on your investments. In one study, long term growth mutual funds were divided into two groups: Those with higher expense ratios than the average and those with lower expense ratios. The funds with lower expense ratios outperformed the other funds by an average of 2 percent a year.

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Once you understand that low fees correlate with higher returns, you will appreciate the latest news from Scottrade. It recently announced the launch of fifteen new low-cost exchange traded funds, through its affiliate, FocusShares. Exchange traded funds are funds that track an index, but they can be traded like a stock. You need a brokerage account to buy or sell them. The expense ratio of these new ETFs is rock bottom low. For example, the Focus Morningstar US Market Index ETF (FMU) has an expense ratio of only 0.05 percent. The traditional leader in low cost ETFs and index funds is Vanguard. Its comparable fund, the Vanguard Total Stock Market ETF (VTI), has an expense ratio of 0.06 percent.

The fact that major fund families are in a price war is good news for investors. But don’t get overwhelmed with all the ETF choices now available. An intelligent investment plan focuses on the allocation of your portfolio between stocks and bonds. Once you have made that determination (You can find a good asset allocation here.), you could put together a very smart portfolio with the purchase of only two funds:

1. The Vanguard Total World Stock ETF (VT), which tracks the performance of the FTSE All-World index. Holding this ETF gives you the market returns of the global universe of stocks. Its expense ratio is 0.25 percent. You could put 100 percent of your allocation to stocks in this fund.
2. The Vanguard Total Bond Market ETF (BND). This fund invests in a broad U.S. investment-grade bond portfolio. You could put 100 percent of your allocation to bonds in this fund.

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If you wanted to take advantage of one of the new Scottrade ETFs, you could consider the following allocation, but you would have to add one more fund:

1. The Focus Morningstar US Market Index ETF (FMU). Consider investing 70 percent of your allocation to stocks in this ETF.
2. The Vanguard Total International Stock ETF. Put 30 percent of your allocation to stocks in this ETF.
3. The Vanguard Total Bond Market ETF (BND). Invest 100 percent of your allocation to bonds in this fund.

Both of these portfolios will provide you with the returns of the global stock market and the domestic bond market at a very low cost. Based on historical data, these portfolios have outperformed 95 percent of professionally managed money over the long term.

Dan Solin is a senior vice president of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, will be released in September, 2011.