Why Do Investors Favor Index Funds with Higher Expense Ratios Over Cheaper Alternatives?

Index funds are a popular choice among investors due to their passively managed nature and generally lower costs compared to actively managed mutual funds. However, despite the availability of cheaper options, some investors opt for funds with higher expense ratios, such as Fidelity Spartan 500 Index FUSEX with an expense ratio of 0.10, over options like Vanguard SP 500 ETF VOO which have a lower expense ratio of 0.05. This article explores the reasons behind this phenomenon and highlights the importance of considering value, convenience, and sales practices in investment decisions.

Factors Influencing Investors' Choices

The choice of investing in funds with higher expense ratios often stems from a combination of factors, including real estate transaction fees, personalized sales pitches, and lower account opening minimums. Here are some key points that illustrate why this happens:

Transaction Fees

In the case of Fidelity, holding Fidelity funds comes with no transaction fees, an attractive feature for investors who prefer to keep all their investments in one place. These transaction fees, while seemingly small, represent a direct cash outflow for the investor. On the other hand, Vanguard funds, while cheaper, may come with lower fees but still have transaction costs associated with buying and selling.

Sales Commissions and Personalized Sales

A subtle but significant factor is that more expensive funds may be pitched by salespeople with higher commissions. These salespeople may have a vested financial interest in promoting funds with higher expense ratios, which can influence their recommendations.

Convenience in Managing Investments

For many investors, the convenience of managing their investments through a single broker with lower required account opening minimums outweighs the few pennies of difference in expense ratios. This convenience can simplify the investment process and provide a sense of familiarity and continuity.

Lower Required Minimums and Brokerage Practices

Some brokerages, like Charles Schwab, have lowered their fund fees to become some of the cheapest in the market. They also offer lower minimum opening deposits, making it easier for investors to start their investment journey. Lower transaction fees and account opening minimums can make these platforms more attractive, even if the expense ratios are slightly higher.

Comparing Specific Fund Options

Let's examine the expense ratios and performance of specific index funds and ETFs. Here are some key data points:

Fidelity Spartan 500 Index Fund (FUSEX): Requires a minimum of $2,500 to start and costs 9 cents per $100 invested annually. (Expense ratio: 0.10%) Vanguard 500 Index Fund (VFINX): Requires a minimum of $3,000 to start and costs 16 cents per $100 invested annually. (Expense ratio: 0.16%) Vanguard 500 Index Fund Admiral Shares (VFIAX): Requires a minimum of $10,000 to start and costs 5 cents per $100 invested annually. (Expense ratio: 0.05%) Charles Schwab SP 500 Index Fund (SWPPX): Requires just $100 to start and charges 9 cents. (Expense ratio: 0.10%)

Interestingly, despite the higher expense ratio, FUSEX is a bit better than VFINX in terms of transaction fees and account opening minimums. Meanwhile, VFIAX offers a slightly better 10-year performance than FUSVX, making it a compelling choice for long-term investors.

Conclusion

The decision to invest in index funds with higher expense ratios, such as FIDE's FUSEX, is not as straightforward as comparing merely the expense ratios. Factors like transaction fees, personalized sales pitches, and lower required account minimums play significant roles in this decision. As such, investors should weigh these aspects carefully when choosing their investment strategies.