In office towers somewhere, nine portfolio management teams are rocking frosted tips and anti-skip discmans like it’s 1999 because they’re getting paid like it is-as much as 12x the modern-day rate just to track an index. As of 2020 (the 2021 numbers aren’t out yet), the average expense ratio for passive funds has fallen to 0.12%. Yet, there are still basic S&P 500 tracker funds with expenses that exceed the average active fund rate of 0.62%. There are virtually no circumstances under which selecting such an index fund makes sense for anyone’s portfolio, save for unfortunate situations where there are no other choices (like a poorly managed 401((k)) or 403(B) retirement plans).
Here are the funds. After the chart, I offer commentary on why these funds shouldn’t exist and no one should still be invested in them.
S&P 500 Funds With Inexplicable Expenses
Expenses Not Explained By Traditional Fund Economics
With average passive expenses at 0.12% as of 2020 (they are almost certainly lower as of today) and the best funds under 0.05%, these funds aren’t even trying to compete on price. As you can see above, there are wide disparities between share classes, suggesting that distribution expenses (12b-1 fees, sub-TA fees, and the like) are heavily driving the most expensive share classes, some of which exceed 1%. That fact alone is problematic. Investors should never agree to pay distribution expenses in passive products for a number of reasons, including primarily that you don’t have to: none of the leading funds (listed later in this article) charge such fees. In any event, many of the cheapest share classes above (with reduced or no distribution expenses) are still double or greater than the passive-fund average. Only one share class of one fund – MM S&P 500 Index Fund Class I Inst (MMIZX) – is in line with the market.
An initial hypothesis as to why these funds are so expensive might be that they are small and haven’t yet achieved scale. But hardly so: only two funds have less than $1 billion in assets, and there doesn’t appear to be a meaningful correlation between the size of these funds and their expenses. Moreover, many are part of large complexes with trillions in assets, and thus would benefit from economies of scale even on day one.
A different hypothesis is a stronger contender: they are simply old with sticky assets (so-called “legacy” funds). In a spectacular development for the author of this article, the average inception date is actually 1999! This is, indeed, relatively aged for passive funds.
It appears that many were able to aggregate assets during time periods when average fees were higher (or the market less educated) and have clung to those assets even as the market has brought prices down around them. At this point, the funds are generally stagnant or shrinking, but not quickly enough: they still hold about $20 billion of somebody’s savings.
The Cost To Investors
As recently noted by Morningstar, what may seem like small fee differences can have significant performance effects over time (one might call this “fee drag”). Morningstar studied the best and worst S&P 500 funds and found that the 10th-percentile (the best) fund beat the 90th-percentile (the worst) fund by 1.3 percentage points per year.
Over ten years, the best fund outperformed the worst fund by 40 percentage points or by $40,000 on an initial $100,000 investment. That’s an enormous advantage, largely driven by fees and expenses (and to a smaller extent tracking error).
Given that the funds above are identical S&P 500 trackers, this amounts to a tremendous wealth transfer to fund managers for no apparent reason. Based on the numbers above, I estimate that the excessive fees and expenses are between $19 million and $136 million per year, and thus as much as $684 million over 5 years and $1.4 billion over 10 years. I calculate this by comparing the fees charged in the cheapest share classes to the passive-fund average and, for the high end of the range, the same as to the most expensive share class.
This estimate is likely conservative for at least two reasons: (1) when the 2021 numbers are released, we will likely learn that the passive-fund average has fallen further; (2) the passive-fund average includes index funds in addition to those tracking the S&P 500, but the latter are generally the cheapest index funds on the market (in other words, comparing the share classes above to the alternative funds listed below would result in an even higher excessive fee calculation); and (3) the calculations do not take into account lost future performance as a result of the fees being extracted from the portfolio. In reality, the harm to investors is likely much greater than even the numbers above suggest.
In exchange for billions of dollars of unjustified expenses over the long term, shareholders aren’t getting anything additional: just overpriced vanilla trackers with highly compensated portfolio managers.
Too Many Alternatives To Mention
What makes the existence of these funds so surprising is the wide availability of vastly superior alternatives. Morningstar identifies Schwab S&P 500 Index (SWPPX), Vanguard 500 Index Admiral (VFIAX), TIAA-CREF S&P 500 Index (TISPX), SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV) and Fidelity 500 Index (FXAIX) as top contenders, but there are of course many, many more. These days, depending on your brokerage account type, you may have access to index funds with zero expenses.
There is simply no reason for any investor, regardless of circumstances, to own one of the high-fee trackers in this article unless there are simply no other passive options available. Financial advisers who have placed clients in these funds have some difficult questions to answer, or perhaps just one: Why? And that’s a hard one. Leave me a comment below if you have any ideas.
What can investors do? As with all mutual funds, investors can typically vote with their feet by selling their shares and replacing them with any of the numerous cheaper alternatives. However, the continued existence of these funds suggests that there are additional forces at work. Investors who have no other options in, for example, an employer-sponsored retirement plan may be forced to try more creative options. At the plan level, those could include asking human resources or your plan administrator to substitute for better options. At the fund level, options could include making a demand on the fund’s adviser to refund the excessive fees or considering other legal options. While circumstances vary between investors, no good can come of owning these funds over the long term. Taking steps now to minimize expenses and maximize market correlation is guaranteed to enhance the returns of your index portfolio.