Do Vanguard Funds Have Hidden Costs?

A reader writes in, asking:

“I recently met with a financial advisor to look over my portfolio. Currently, I use the ‘three fund portfolio’ that is recommended on the Bogleheads website: Vanguard’s total stock, total international, and total bond funds. The advisor said that while Vanguard index funds are OK, he thinks they’re over-rated because they have hidden costs and they aren’t actually as cheap as Vanguard states in their marketing. Is that true?”

Every typical mutual fund (index or otherwise) has “hidden costs” as a result of portfolio turnover. That is, when a mutual fund buys or sells investments, it incurs costs in the form of commissions and bid/ask spreads. And these costs are hidden in the sense that they are not included in the fund’s reported expense ratio, despite the fact that they have a downward drag on performance.

What’s ironic about this advisor’s assertion is that:

1. Index funds (especially “total market” funds) tend to have very low turnover costs, and
2. It’s much easier to estimate an index fund’s turnover costs than an actively managed fund’s turnover costs.

In other words, relative to the hidden costs of actively managed funds, the hidden costs of index funds are typically a) less hidden and b) lower.

Why Index Funds Usually Have Lower Turnover Costs

The reason why index funds typically incur lower portfolio turnover costs than actively managed funds is simple: index funds generally have a lower rate of portfolio turnover.

For example, Morningstar currently reports that Vanguard Total Stock Market Index Fund has annual portfolio turnover of just 3%. Look up any handful of actively managed stock index funds, and the most likely outcome is that all of them will have portfolio turnover well in excess of 3% per year.

How to Estimate the Turnover Costs of an Index Fund

With index funds, it’s pretty easy to get an idea of the magnitude of such hidden costs. To do so, check how the fund’s long-term performance compares to the performance of the index that it tracks. For example if:

• A given index has an annual return of 7.0% over the last 10 years,
• A particular index fund tracking that index has a return of 6.85% over those 10 years, and
• The fund has an expense ratio of 0.1%…

…then we can estimate that the fund’s “hidden costs” are in the ballpark of 0.05% per year. (That is, if the fund’s performance trails the performance of its benchmark by 0.15% per year, and the fund has a 0.1% expense ratio, the remaining 0.05% performance gap serves as a decent estimate of such “hidden” portfolio turnover costs.)

With regard to the advisor’s assertion about Vanguard specifically, it’s worth pointing out that, in many cases, Vanguard’s index funds actually trail their benchmarks by an amount that’s less than their expense ratios. In other words, the hidden costs are sufficiently small that they are outweighed by the “hidden revenue” the funds earn from securities lending.