Index Funds vs. Active Management: Do Advisory Fees Cancel Out Your Savings?
The Critical Question: Do Advisor Fees Cancel Out Index Fund Savings?
The main benefits of index funds are low cost and market efficiency. However, does the additional fee charged in fee-based accounts reduce or eliminate much of that low-cost advantage, and does the proliferation of index investing eventually make the market less efficient?
About one-third of active managers outperform their indexes. However, it would be interesting to see what percentage of index funds outperform active managers after the advisor fees are taken into account. Are active managers with lower expense ratios, such as American Funds and Dimensional Funds, more likely to outperform index funds, especially net of an advisor fee?
The Hidden Cost of "Fee-Only": When Advisory Fees Outweigh Benefits
The theory behind a level fee for financial professionals was that if advisors were paid the same regardless of what product they offered a client, the advice a client relied on would be better. Much of the government’s angst stemmed from financial professionals recommending that retirement plan participants roll over their 401 (k) accounts into annuities that paid high commissions and weren’t suitable for retirement funds.
Fee-only advisory accounts and index funds have benefited from the Fiduciary Rule. In contrast, mutual fund direct accounts have faced some challenges. In a direct mutual fund account, investors could transfer their 401k to an IRA directly. For example, American Funds offers an excellent range of actively managed funds with an expense ratio of around 0.60% and a tiny administrative fee of $10. If the rollover account is substantial, the commission can be as low as 0% or 2.5%, depending on the rollover size. At 2.5%, it would take only a few years for the IRA holder to pay thousands less in costs than in an advisor account with a 1% advisory fee, even if funded with low-cost index funds.
About Tim: How I Navigate Both Worlds for Clients
I am registered under the 1934 Securities Act and the 1940 Advisors Act, allowing me to operate either fee or commission accounts. A fee account is a brokerage account with a fee wrapper, while a commission account using mutual funds is typically held directly at the fund company, often American Funds.
In a fee account, fund fees, when using index funds, may be around 0.05%, plus an advisory fee paid to the advisor that is typically around 1%, totaling roughly 1.05%. In a commission account, the client pays a commission upfront and then fund fees, which average around 0.60% in the case of American Funds. Most mutual fund direct companies use actively managed funds. At the same time, advisory accounts use more index funds to offset the advisory fee.
The Unstoppable Rise of Index Funds
Index investing, a strategy that involves owning a fund that tracks a particular index like the well-known S&P 500, has gained significant traction in recent years. At the end of 2014, index funds (including ETFs) held $4.2 trillion in assets, but this number skyrocketed to $13 trillion by 2023, surpassing the assets held in active management.
The beauty of index investing lies in its simplicity: There’s no stock or bond picking involved. Instead, the fund owns the same stocks in the same proportion as the index, based on the company’s market capitalization. For instance, Microsoft stock represents 7% of the S&P 500 index. This index is dominated mainly by six stocks, namely Microsoft, Apple, NVIDIA, Amazon, Meta (Facebook), and Alphabet (Google), which account for 26% of the index.
It’s worth noting that the growth of index funds saw a significant boost after the introduction of the 2015 Fiduciary Rule. Since this rule encouraged financial professionals to be licensed as investment advisor representatives to provide fee-based accounts to clients, it led to a shift in investment strategies.
Advisors and consultants to retirement plan fiduciaries started recommending the elimination of active management funds with 12b1 fees (fees paid out of mutual fund or ETF assets to cover the costs of distribution) from their plans and the addition of more index funds. This change meant that any compensation to advisors or consultants remained the same regardless of the funds that plan participants used.
A Warning Sign: Could Index Investing Make Markets Less Efficient?
If a small group decides to start commuting to work at 5 a.m., they will benefit from less traffic. However, if everyone starts doing the same, nobody will benefit. This is an example of what’s called the tragedy of the commons.
The concept of index investing originated when active management was at its peak. Skilled portfolio managers—such as Peter Lynch at Fidelity, John Neff at Wellington, and John Templeton—analyzed companies and selected stocks for their funds’ portfolios based on fundamentals. This resulted in a more efficient market with fewer misplaced stocks. Indexing then took advantage of this efficient market by providing investors with lower investment costs. However, as more and more people turn to indexing for investing, the question arises: Who will keep the market efficient?
How the Fiduciary Rule Changed Financial Advice (2015-Present)
Over the past decade, the financial advice industry has undergone a significant transformation. Previously, most financial professionals were incentivized by commissions to sell financial products, often from their employers’ proprietary offerings. The industry has moved toward a fee-based model with more impartial financial advisors and planners who have fewer conflicts of interest. (The one exception is the K-12 403b market, where commission products remain the norm.)
In 2015, the Obama administration introduced a game-changing regulation known as the Fiduciary Rule, which was intended to ensure that most financial professionals offering advice on retirement plans, including IRAs, were fiduciaries. A fiduciary, as we know, manages assets on behalf of someone else and is required to put the client’s interests ahead of their own. This rule was designed to reduce or eliminate conflicts of interest. Many financial companies and professionals were compelled to switch to a fee-only compensation model to comply with this regulation.
The courts eventually overturned the Obama administration’s 2015 Fiduciary Rule. Despite this, the Trump administration implemented parts of it, though it excluded the requirement that advisors provide a level-fee cost structure for clients.
In April 2024, the Biden administration introduced its own Fiduciary Rule. This rule aims to close loopholes by requiring that one-time advice—like rolling over a 401(k) into an annuity—be held to a strict Fiduciary standard, rather than just the Best Interest standard used by the SEC. However, federal courts vacated this rule in March 2026, and the DOL has confirmed it is reverting to the original 1975 fiduciary standard rather than pursuing the 2024 rule further.
If implemented, the rule would have required insurance companies to eliminate potential conflicts of interest. For example, financial professionals could not have received special treatment—such as the employer paying more of their health plan’s premiums—just because they sold more of a company’s proprietary products.
Conclusion: The Future of Retirement Advice
Almost ten years into this transition, my guess is there are fewer IRA rollovers from 401ks into variable annuities. If the Biden administration was successful, the same would have held for fixed annuities. (The courts, much like President Obama’s first Fiduciary attempt, have stopped Biden’s.)
Even so, fees to retirement plan participants have probably come down as more plans have introduced institutional share classes and index funds. For IRA rollovers funded with mutual funds and ETFs, there are a lot more fees and a lot fewer commissions paid, and time will tell whether that ends up being a good thing.
“I have been served for over 20 years and plan to continue working with Tim. Tim is an intelligent, well-educated, and kind man. Tim has always been available by visit or by phone. He explains what is going on financially and makes every effort to explain and discuss our relationship. It is my pleasure to rate Tim as A+ in all our interactions. I am very pleased with the man, and how he serves his clients as to financial advising.”
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These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice. Content provided via links to third-party sites should not be considered an endorsement of content that we cannot verify completeness or accuracy of.