A reader asks this question: "I stumbled across some information on Vanguard's Web site about what they call the 'Investing Truths.' One of them is about costs and shows that a 1.2% expense ratio would eat up 46% of an 8% return over 50 years. Can that be true?"

The short answer is "yes". Based on a hypothetical investment of $10,000, a fund with an expense ratio of 1.2% would yield $248,322 to the investor and a whopping $210,693 to the fund.
An expense ratio of 1.2% is less than the average (1.50%) for actively managed funds (funds where the manager attempts to beat the returns of a benchmark, like the the S&P 500).

What if you could buy an index fund that tracked the same benchmark? The expense ratio of the index fund would be around 0.2%. The same investor would reap returns of $414,425. The fees to the fund would be only $44,590.

But do the more expensive funds outperform the cheaper ones?

That's the surprising part. High expense ratio funds typically underperform lower cost funds. Low cost index funds typically outperform actively managed funds of comparable risk over time.

High expense ratio funds are made to be sold and not bought. The are lucrative for the broker who sells them and for the mutual fund family that runs them.

You should avoid them.

Dan Solin is the author of the newly published book,
The Smartest Retirement Book You'll Ever Read (Perigee Books, 2009). His prior books include the New York Times bestsellers The Smartest Investment Book You'll Ever Read and The Smartest 401(k) Book You'll Ever Read. See SmartestInvestmentBook.com.

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