by Archie M. Richards, Jr., CFP^®
September 15, 2003

I recommend Vanguard mutual funds often enough that you may have wondered, "Does that guy work for Vanguard, or what?"

I do not work for Vanguard, and I don't receive income from it. Vanguard simply remains a shining light in an industry that has turned to the dark side.

In most industries, as the volume goes up, the cost per item goes down. Not so with mutual funds.

Oh, the industry has grown, all right. In 1984, mutual funds managed $77 billion of stocks, with annual operating costs averaging 1.2 percent. In 2002, mutual funds managed $2.7 trillion of stocks, with annual operating costs averaging 1.6 percent. The assets went up by 35 times, but per-unit costs rose by a third.

Mutual funds have run counter to normal economic behavior. Could this be because they're closely regulated by government? I see the Richards Rule of Government in operation, namely, the actual long-term results of most big government policies are opposite to the intended results.

Jack Bogle, founder and former chairman of Vanguard, spends his time researching mutual funds and preaching that they're charging too much and trading too much. He's my kind of guy. Here's a summary of the costs he's found:

Start with the 1.6 percent annual operating costs mentioned above.

Add excessive trading. The average stock fund turns over its portfolio every 11 months. Because of commissions and spreads between bid and asked prices, buying and selling costs money. (A "spread" means that if you buy a stock, you pay more than you would receive if you sold the same stock at the same moment.) Bogle estimates that trading by stock mutual funds costs investors approximately 0.8 percent per year.

That's 2.4 percent so far. Now add sales charges and other expenses. Overall, Mr. Bogle estimates that the annual costs of the average stock fund total 3 percent per year.

Funny coincidence: Mutual funds fall short of market results by about 3 percent. From 1984 to 2002, the Standard & Poor's 500 Stock Index rose by 12.2% a year. During the same period, the average stock mutual fund gained by 9.3 percent per year. The difference (2.9 percent) is due almost exclusively to costs.

Vanguard is quite a different story. Its costs and turnover rates are low. The annual operating costs of the Vanguard stock funds I favor average 0.33 percent. The turnover rates average 38 percent, probably resulting in annual costs of 0.4 percent. Throw in a few other costs (no sales charges), and you're looking at total costs no more than 1 percent - probably less.

For the average stock mutual fund, the annual costs total 3 percent. For the Vanguard stock funds I recommend, 1 percent.

This makes a bigger difference than you might think. Let's say you invest $10,000 in each of two funds. Before costs, both funds earn 11 percent a year. Dividends are reinvested.

Fund A's costs are 3 percent per year, leaving a net return of 8 percent (11 less 3).

Fund B's costs are 1 percent per year, leaving a net return of 10 percent (11 less 1).

In 30 years, Fund A is worth $100,600. Fund B is worth $174,500.

That's 73 percent more, solely because of lower costs!

This doesn't even take into account individual taxes. Fund A turns over its stocks more often than once a year, producing short-term capital gains taxed at high rates. Fund B produces primarily long-term capital gains taxed at newly-reduced low rates. The after-tax difference between Funds A and B is greater than 74 percent.

Yes, I have good reason to stick with Vanguard funds. The cost savings make a huge difference.

Mr. Bogle also points out that most investors buy and sell their stock funds too much. In the effort to catch market swings, they invariably catch the swings wrong. From 1984 to 2002, the average mutual fund investor gained just 2.7 percent a year, a huge shortfall from the 9.3 percent return of the average stock fund and an even worse shortfall from the stock market's 12.2 percent return during the period.

Buy Vanguard index funds and just hang on.