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Index fund fees matter most

By Jennie L. Phipps · Bankrate.com
Tuesday, December 6, 2011
Posted: 4 pm ET

A team of economic researchers at Harvard University and Yale University rounded up MBA students and staffers and asked them to choose which index funds were the best investments.

Despite having loads of experience and lots of brain power -- the MBA students were from the Wharton School at the University of Pennsylvania, one of the country's most prestigious business schools -- this group of investors made all the wrong choices. They chose to invest in index funds that had high fees because their prospectuses boasted about the funds' great track records. These investors were blinded by the sales pitches. But past performance doesn't mean diddly when it comes to index funds, says Brigitte Madrian, professor of economics at Harvard and one of the authors of study.

In the case of index funds, "Past performance isn't a good predictor of future performance. Last year's performance doesn't predict next year's performance -- especially in this market," says Madrian.

So why did people who ought to know better make poor choices, and what can those of us who aren't investment geniuses and can't afford to make retirement planning mistakes learn from this that will protect us from buying the wrong index funds?

  • Insist on knowing what the fees are. Fees aren't usually included in quarterly reports, and nobody shows what the return might have been if there had been no fees. But that shouldn't stop you from finding out what the fees are and favoring index funds that are competitively priced.
  • Keep fees top of mind. Madrian says people aren't conditioned to think about fees, but that ought to be the first consideration when buying index funds.
  • Shop around. The same people who would never think of going to the store and choosing the highest-priced product on the shelf buy pricey index funds because they don't understand how pricey they are. Madrian says to compare fees on several funds before investing.

This project -- and Madrian-- was honored by investment firm TIAA CREF for its clarity and importance because fees can really eat up investment returns, especially for retirees. Even a small difference can over the long haul have a big impact on retirement funds.

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1 Comment
Evan
December 08, 2011 at 9:46 am

Fees are a major part of your 401(k) plan. It is important you take time to understand the fees associated with your specific plan.