I am often reminded when talking with friends and coworkers that most people don’t understand the important of low fees when it comes to investing. The Vanguard blog had a recent post exploring why a 1% expense ratio is much more significant than it appears. The problem is that expense ratios aren’t charged to you directly as a line item like an overdraft fee or a monthly bill – it is quietly taken away in tiny pieces from your returns which makes it easy to ignore.

For another, fees are expressed as a fraction of assets. A 1% equity management fee seems small and reasonable. “One percent” just sounds tiny – as in “there’s a 1% chance of rain tomorrow.” But suppose you reframe fees in other terms. Suppose you expect a stock fund to earn 8% over the long run. Assuming inflation of 3% and a tax rate of 25%, you’re in effect paying one out of every three dollars of future expected return in costs.* A fee of “one third of all of the money you make” sounds like a lot, especially when many money managers could do worse than the market averages.

Basically, if you are expecting to earn 3% a year above inflation after taxes, paying 1% to a manager is like paying 1/3rd of all your earnings. As you can see below, I could own the S&P 500 for as little as 0.05%. Things get even worse when looking at bond funds and their tiny yields.

Research has shown repeatedly that costs matter more than star ratings and past performance. The lower the expenses, the less headwind year in and year out.

With that knowledge, Vanguard has announced another round of fee cuts! Vanguard says the price drops are a result of them being client-owned and passing on any savings resulting from increased assets. Others speculate that it’s a reaction to competition from other low-cost ETF providers like Schwab. Either way, investors win. The drops are pretty small, but to me it’s like getting a little guaranteed boost in returns that will compound every year. A selected sample of funds with fee drops below:

Admiral shares are now open in most index funds with a $10,000 investment, and you can always start like I did with the Investor shares at $3,000 and convert to Admiral when the balances grow. ETFs usually offer the same low expense ratios as Admiral shares, but you should also keep in mind the cost of trade commissions. Buying Vanguard ETFs and mutual funds directly with an account with Vanguard is free. TD Ameritrade also offers commission-free trades on a wide variety of Vanguard ETFs (along with other providers).

Over the last year or so, Vanguard has made several moves that lowered my portfolio costs. They added Admiral shares, removed purchase fees on their Emerging Markets fund, and dropped expense ratios again.

Weekly business newspaper Barron’s recently released their 2012 annual broker survey rankings. A change from last year is that now the quality and availability of mobile apps for smartphones and iPads are now part of the criteria, as well as more attention paid to the ability to place transactions directly on international exchanges.

Barron’s admits their overall rankings are based on the needs of their paying subscribers – namely “wealthy, active traders”. As such, their overall winner was Interactive Brokers, which has an extensive feature set with low per-trade commissions but also requires a minimum opening balance of $10,000, a minium monthly fee of $10, and is lacking customer service especially for smaller investors.

I am not an active trader, I would say I do less than 50 trades a year mostly using ETFs. Based on no data whatsoever, I would guess that most readers here are also not active traders and don’t need a full-service terminal with real-time streaming charts and complex options order-entry capability. (Although I know some of you are.) Now, I still like having real-time quotes, a nice user interface, and friendly service when I need it. So thankfully Barron’s also ranked the brokers for other investing styles:

Top 5 Brokers for Novice Investors

1. TD Ameritrade. Notes above-average costs, but more features and good mobile app. Curiously, no mention of the 100 commission-free ETF list.
2. Fidelity
3. E-Trade
4. Charles Schwab
5. Capital One 360 Sharebuilder

Top 5 Brokers for Long-Term Investing

1. Fidelity – Notes good mix of reasonable cost, research tools, and overall usability.
2. TD Ameritrade
3. Charles Schwab
4. E-Trade
5. TradeKing

Top 5 Brokers for In-Person Service

1. Scottrade. Notes over 500 physical branches across US.
2. Merrill Edge
3. Charles Schwab
4. Fidelity
5. TD Ameritrade

I found it weird that they mention Scottrade’s meager list of proprietary commission-free ETFs that nobody hardly uses, but completely ignore the fact that TD Ameritrade includes 100 of the world’s largest and most heavily traded ETFs on their commission-free list. I guess they really are laser-focused on daytraders and people trading on Asian exchanges in the middle of the night.

There will always be debate regarding investing in actively-managed stock pickers vs. passive index followers. But even for active managers, costs matter more than star ratings and past performance. The lower the expenses, the less headwind year in and year out.

The best thing about using Vanguard funds is that they have consistently lowered my investment fees over time as their own costs have dropped. When that happens, it’s like getting guaranteed higher returns that continue to compound each year.

Last year, they lowered the fees on several funds and also added Admiral shares. Last month, they dropped some fees on their Emerging Markets fund. Most recently, they announced another round of expense ratio cuts. Check the article for all the funds, but here are the ones that I hold:

The total weighted expense ratio of my investments is probably under 0.20% annually now. The only way to go lower is to hold the stocks or bonds directly in a brokerage account, and even then I have consider commission charges.

The Calafia Beach Pundit has an interesting discussion on TIPS (inflation-linked bonds). What caught my eye was a nice chart of historical TIPS real (after-inflation) yields vs. Treasury nominal yields. The difference is what inflation would have to be for them to pay out the same total yield, called the “breakeven inflation rate”. If actual inflation is lower, then Treasury bonds end up paying more. If actual inflation is higher, then TIPS pay more. (I’m not really sure why the breakeven inflation rate is on a different scale.)

It’s interesting how relatively steady the breakeven inflation rate has been. The low breakeven inflation rate back in 2009 was a good time to stock up on TIPS. Today, the expected inflation is about the same as historical average but real yields are at historical lows. He concludes:

To sum up: TIPS are only attractive to an investor who believes 1) that inflation will prove to be higher than expected, and 2) that economic growth will continue to be disappointing.

I’m still holding a position in TIPS in my portfolio asset allocation. I have historically overweighted them with high real rates, and today I am slightly underweighting them due to low real rates. They’ve done their job though, helping keep me off the Pepto Bismol during these last few years.