TVs and mutual funds: Do you get what you pay for?

Posted by on March 20, 2012 @ 10:08 am in Investing

Two years ago, my husband and I bought a TV. He wanted the super-duper one. I wanted a good deal. We went with the good deal.

Fast-forward two years, and the TV we got only turns on and off when it wants to. Now, every time the TV goes on the fritz, my husband resists the urge to say, “You get what you pay for.”

While he was right in this specific instance, does the adage “you get what you pay for” apply in every situation?

Of course not. For instance, what if I told you this was how we’re going to go about the process of replacing the TV:

We’ll start off by setting criteria for the purchase. My husband will want the biggest, best 3-D TV on the market (I’d go into more detail, but I’m clueless when it comes to TVs). I will want something practical. We’ll compromise, and then he’ll use the criteria we decide on and will totally geek out. He’ll read a ton of consumer reviews to find the best possible brand and model within our criteria. I’ll find this part of the process boring and will abstain until he’s ready to make a purchase.

Sounds typical so far, right? Well, what if we concluded the process like this:

After deciding on a brand and model, we go online and find who’s selling the model we want at the highest price. We buy it from that company, because there must be something special about the most expensive seller’s inventory if they can get away with charging the most, right?

Obviously, this would be a ridiculous and wasteful approach. While it might make sense to pay more for a better product, it doesn’t make sense to purchase the same product from a store that charges a premium. The old adage clearly doesn’t apply here.

What if I told you we’re going to apply similar logic to select an investment for our retirement portfolio? Will “you get what we pay for” apply?

We’ll start off by setting certain criteria. We’ll discuss investment goals, decide how much risk we’re willing to take, and we’ll determine the right mix of stocks and bonds to reach these goals. Then we’ll determine the type of investment that will help us get to the right allocation. Let’s say we determine we need to add stock exposure to our portfolio and conclude that we should purchase an index mutual fund that tracks a benchmark of U.S. stocks.

Then, we’ll do some research and will identify a handful of index funds that track that same index and meet the criteria we set. Finally, we’ll conclude that we should purchase the fund that charges the most (the highest expense ratio) under the assumption that a company that’s able to justify charging more must be able to deliver superior results because “you get what you pay for.”

When the faulty purchasing logic I proposed for replacing our TV is applied to selecting a fund, does it seem more rational? Do you get what you pay for in the form of superior performance?

Let’s say you’re deciding between two index funds that seek to track the same index. The goal of both funds is the same: replicate the returns of that index. All else equal, the fund charging a lower expense ratio will allow you to keep more of the returns the fund produces, while the fund that charges more does just that—it charges more. And the difference can be substantial. If you chose to invest $10,000 in the lower cost index fund instead of investing in a similar fund that charges the average expense ratio for the fund category, you could get to keep about $2,575 in additional returns over a 10-year period.*

What about actively managed funds? Generally, the same logic applies: the more an active fund manager charges for management, the more ground she needs to make up before she can begin generating returns that beat a benchmark, and the less you keep in the form of returns.

*Based on a hypothetical $10,000 investment with an annual rate of return of 9.86% over a period of 10 years, assuming no additional investments in the fund. Stock returns historically have averaged 9.86%, based on the total average annual return of the Standard & Poor’s 500 Composite Stock Price Index from 1970 through 2009. However, this illustration does not represent the return on any particular investment.

The illustration contrasts a hypothetical 0.06% expense ratio for a low cost index fund ­ with the 1.12% industry average expense ratio. The information is supplied by Lipper, Inc. as of 12/31/2011

Note: All investments are subject to risk. The performance of an index isn’t an exact representation of any particular investment, as you can’t invest directly in an index

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