Author Topic: Why are we so averse to high expense ratios?  (Read 7049 times)

g3

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Why are we so averse to high expense ratios?
« on: July 07, 2014, 06:21:16 PM »
Hello Mustachians!

I've been an active visitor on this site for just over a week - I've already learned a ton and look forward to learning more as I get specific questions answered.  A quick about me before getting into my first Ask a Mustachian -- I'm a 22 y/o college grad and I just started my working career as an engineer.  I've been fanatically educating myself about investing and only recently learned the importance of extreme saving upon visiting this site -- thank goodness I've only been in the working world a few weeks!

Now to the good stuff:

I've seen plenty of articles online and wisdom here about the necessity of investing in a low cost index fund to avoid expense ratios that will subtract a major percentage of your portfolio over time.  Here's one:  http://www.nytimes.com/2014/03/02/your-money/give-fees-an-inch-and-theyll-take-a-mile.html?_r=0

Obviously, it would make sense to invest in a low cost index fund if we believed it would return the same amount as a high expense ratio one.  But, what I am seeing is that some high expense ratio funds are performing wonderfully on the 'hypothetical investment of $10,000 over 10 years'.  Specifically among my limited 401k options, DREGX (1.66%) and SKSEX (1.47%) have vastly outperformed low cost indices.  Even the Vanguard funds that are Vanguard high (say >0.20%), VGHCX (0.35%) and VGENX are dominating the passive funds.

There must be some aspect I am overlooking here and so I turn to you to straighten me out my fellow Mustachians and rationalize why I should invest in FSPNX (0.10%) and FSKTX (0.07%) instead!

AlmostIndependent

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Re: Why are we so averse to high expense ratios?
« Reply #1 on: July 07, 2014, 06:30:38 PM »
The catch is that those high expense funds have to outperform the market year after year after year. That, unfortunately, is extremely difficult to do. Lots of people out perform the market in a given year, stretch that out to 10 or 20 years and the ranks of market out-performers dwindles.

ampersand

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Re: Why are we so averse to high expense ratios?
« Reply #2 on: July 07, 2014, 07:41:57 PM »
Below are two articles that answer your question a little (strike that-a "Lot") better than I can. I'll summarize though if you don't want to read them. About 80% of actively traded mutual funds lag the market. Thats not to say that there are not actively managed funds that do better, but they face a strong headwind; Increased trading creates fees, increased turnover causes taxation (most mutual funds get taxed internally even if you hold them in your 401k). So if you're willing to do the research, keep an eye on your portfolio managers, and be willing to ride out bad years... You might try one of the active funds. The odds are poor but not overcomeable.

http://www.fool.com/School/MutualFunds/Performance/Record.htm
http://www.fool.com/mutualfunds/indexfunds/indexfunds01.htm

Middlesbrough

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Re: Why are we so averse to high expense ratios?
« Reply #3 on: July 07, 2014, 07:56:40 PM »
I have seen similar things, but with even lower expense ratios. My firm is large enough that we have a big enough portfolio combined to get the best class of shares for mutual funds. In some cases, it makes sense to me to grab a couple of those mutual funds that provide areas not covered by the passive indices "indexes" available to us such as foreign indices or bond funds. The difference is the active funds expense ratio are .4-.5% verses .05-.1% for the passive indices.

If you feel you have a good active fund to choice, I think you should put some active funds into your asset allocation if you feel they will do better.

hexdexorex

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Re: Why are we so averse to high expense ratios?
« Reply #4 on: July 07, 2014, 08:03:48 PM »
Your comparing funds over probably the past 5 years that are both small growth funds to cheap index funds that are large growth (or value funds).

When the market is up usually small growth funds will significantly outperform the large ones.

I not only dislike high cost mutual funds because of their fees but I think what they are claiming to do is next to impossible. Most of them have 1000+ stocks and hardly anyone can outperform the market when they are spread out that much. 95% these market fund managers spend their time trying to get more clients to sign up for their fund rather than reading annual reports etc.

When I invest in none index funds or mutual funds I prefer to copy great managers that invest in 5-15 stocks and put all their money in those stocks. Its really the only way to significantly do better than the market.


Khan

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Re: Why are we so averse to high expense ratios?
« Reply #5 on: July 07, 2014, 08:44:48 PM »
As others have stated, you're making an apples to oranges comparison.

If you have the choice between two S&P500 funds, we'll say Vanguard(VFINX), and Morgan-Merrill-Goldman's rape fund, with an ER of 2%, front end load fees, etc. The choice should be obvious.

If however, you're analyzing between the ER of a small cap index fund, which -has- to have higher fees due to increased holdings, and larger lot sizes, compared to a mega-cap market fund, there are more forces at work, and more homework to do.

Nobody (IMO) should just invest in the S&P500 fund, calling it "The market" and saying nothing could possibly beat it, but it's not wrong that so many choose to do so. People shouldn't ignore big-cap non-US funds, or small cap, or other investment vehicles.

But when the choice is between Dodge and Cox's somewhat DGI-value fund, vs. Blackrock's equivalent, Blackrock has lower fees(in my offerings), and so I go with them.

g3

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Re: Why are we so averse to high expense ratios?
« Reply #6 on: July 07, 2014, 08:53:59 PM »
Your comparing funds over probably the past 5 years that are both small growth funds to cheap index funds that are large growth (or value funds).

When the market is up usually small growth funds will significantly outperform the large ones.

Not so.  Compare the 14 year history of a passive index tracking fund, say VTSAX (0.05% ER) vs. DREGX (1.66%) .  Present value of DREGX would be more than double that of VTSAX.  I was struggling to find a long term S&P 500 index to drag the comparison out beyond 14 years, but I'd anticipate similar results.

I do see the logic that a couple of you have brought up in being able to beat the stock market with a less diverse selection, albeit a risky proposition.

Breck

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Re: Why are we so averse to high expense ratios?
« Reply #7 on: July 07, 2014, 08:57:59 PM »
I'm in a similar situation. Graduated in 2012 and have been working as an engineer for 2 years. Just started getting serious about managing investments and planning for early retirement.

There are two thoughts I had when considering your post:

1. There will always be funds that beat the overall market, but they tend to change year to year. Chasing them down may be worth the returns, but it's not unlike picking individual stocks (less risky tho).

2. In the long term most funds track the overall markets in which they invest. And with a high ER, generally the investors (you) get results that underperform.

However, famous economist John Maynard Keys once said, "But this long run is a misleading guide to current affairs. In the long run we are all dead." If you have the time and willpower,  I think market beating performance is possible. For me personally, well there's other things I'd rather be doing.

But, as a fellow engineer, I think it's fun to leave behind the common convention and look at the numbers for ourselves.

I used this tool to compare the effects of expense ratios on an investment. Note that it compares funds assuming the same return. However, it gives a visual idea of why a high ER can really kill an investment. Boils down to this: the compounded value (final value) of the principle removed by the high ER is much higher than the actual amount that leaves your account every year.

On to actual performance. I threw in DREGX, VEIEX (another emerging markets fund), and VGENX into the Fidelity 10k/10yr tool - results.

The final values are 38.5k, 28.4k, and 34.8k respectively. Impressive performance by DREGX. I did notice that the turnover rate is much higher: 264% (DREGX), 26% (VEIEX), and 17% (VGENX). If it's in a 401k though I don't think it should matter as much.

As others have already mentioned you need to compare funds with similar composition and risk to actually observe the managers performance. The initial case for DREGX looks promising, but I don't know enough about the market or competing funds to make a recommendation.

g3

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Re: Why are we so averse to high expense ratios?
« Reply #8 on: July 07, 2014, 08:58:46 PM »
As others have stated, you're making an apples to oranges comparison.


Am I?  I'm not doubting the benefit of low expense ratios where the expected return is similar to that of a high expense ratio index.  Rather, that some select higher ER funds have dominated the market over extended periods of time (~30 yrs).

I wholeheartedly agree that exclusively investing in S&P may be unwise, but then how do you balance the portfolio with low cost investments and pricier active ones?

g3

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Re: Why are we so averse to high expense ratios?
« Reply #9 on: July 07, 2014, 09:04:54 PM »
Also Khanjar -- I'd never heard of BlackRock until you mentioned it.  Always interesting to see a new investment site. Thanks. 

Breck -- I appreciate the response and agree with all your points.  The number crunching doesn't make it any easier on us as it makes us want to defy conventional wisdom.

mxt0133

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Re: Why are we so averse to high expense ratios?
« Reply #10 on: July 07, 2014, 09:22:03 PM »
So I just did a comparison of DREGX vs VTSAX over the past 10 year period.

Go to https://www.google.com/finance?q=DREGX&ei=-l67U-jIFJGmqQHA6YCACA and compare it to VTSAX.

For the past 10 years VTSAX actually outperforms DREGX. But compared back to 2001 DREGX is up like 140% vs 65(ish)%.  Pretty dam good, but then when you take into account the fees of 1.66% plus 265% turnover, short term capital gains, the difference get's significantly smaller.

So like some people here has already said if you can pick the right fund then great, but the fact that 80% of the funds do not beat passive index funds you better have a good crystal ball to pick the right fund.  The higher fees and turnover, causing taxable events, just has the deck stacked against you.  It's like a casino always having higher odds of success vs the players, sure some people will get lucky but in the long run the house always wins.

Here is a fund fee calculator to help you with more in depth analysis to help you see the impact of fund fees:

http://apps.finra.org/fundanalyzer/1/fa.aspx

Middlesbrough

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Re: Why are we so averse to high expense ratios?
« Reply #11 on: July 07, 2014, 09:45:18 PM »
My work 401k is as follows

Bond Funds: 5%
ER- 0.63% (Return minus ER since inception - 7.59%)
and ER- 0.50% (RSI - 10.25%)

Income and Growth: 10%
ER- 0.29% (RSI - 16.17%)
ER - 0.74%? (Prospectus wouldn't load) (RSI - 10.11%?)

Target Date - 5%
ER - 0.47% (RSI - 13.86%)

Large Growth - 5%
ER - 1.2% (RSI - 16.39%)

Indices - 35%
ER - 0.05% (RSI - 7.35%)
ER - 0.09% (RSI - 7.84%)
ER - 0.09% (RSI - 8.79%)

Emerging Markets Small Cap - 15%
ER - 0.72% (RSI - 12.05%)

Emerging Markets Mid Cap - 10%
ER - 1.01% (RSI - 13.96%)

Emerging Markets Large Cap - 15%
ER - 0.49% (RSI - 13.70%)
ER - 0.87% (RSI - 14.56%)

g3

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Re: Why are we so averse to high expense ratios?
« Reply #12 on: July 07, 2014, 09:52:23 PM »
mxt1033 -- Neat fund fee site.  Thanks for the share. 

Short term capital gains would not be a concern for me in a 401k, but with VTSAX actually outperforming DREGX over the last decade, I definitely see your point.

Middlesbrough -- Thank you!  This seems like a reasonable template to start making my 401k selections.  I've been sitting in the default target date fund for a few weeks trying to make sense of it all.

JamesAt15

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Re: Why are we so averse to high expense ratios?
« Reply #13 on: July 07, 2014, 11:12:20 PM »
I'm sure you've heard the phrase, "Past performance is not indicative of future results." It takes a while for this phrase to stop sounding like a bit of throwaway, cover-your-ass legalese, and become something a bit deeper.

A fund may have performed well over the last ten years because of many things. Maybe they really have good management and insight into the markets that allow them to outperform. Or maybe they got lucky and were in the right place at the right time. Maybe they're tilted slightly towards a particular sector or stock that happened to do well over this time period and so the fund outperformed. Was that tilt due to skill of the management, or basically a lucky guess? If it was skill, will that skill apply again to how the fund will perform in the next ten years, which may be very different?

The point is, you don't know. You're almost certainly going to be in a position where you can't know. And so the good results of this particular fund can't be counted on to predict if the fund is going to perform well in the future.

If you eliminate the past results of this fund from your decision making process, do you have any reason to believe it will outperform in the future? "Superior management and analysis" may come to mind, but without using the past results do you have any reason to believe this fund's management has it?

Grog

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Re: Why are we so averse to high expense ratios?
« Reply #14 on: July 08, 2014, 03:04:10 AM »
There are only a few things you can actually control when choosing an investment fund (etf or mutual)

- Type of assets (bonds, equity,REIT, small cap, value, large cap, country-specific)
- Currency in which the fund is (USD, EUR, CHF, etc)
- Dimension of the Fund and traded volume
- Total expense ratio


As you can see, return is not one of them. You can't control return and you can't see into the future. Maybe the really brilliant active manager will be unable to work because of an injury. Mabye it was only luck and he was throwing dart.

The only thing in YOUR control is to choose the fund reflecting the asset class you want to invest in and optimize the other paramaters.

You can pick a 0.05% expense ratio fund and hope that it 'll do great
Or you can pick a 1.66% e.r. fund and hope it'l do great
Between the two, I go with the first option.

wtjbatman

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Re: Why are we so averse to high expense ratios?
« Reply #15 on: July 08, 2014, 03:52:16 AM »
I find that sometimes you need to look at fund names and not just their tickers. You're talking about comparing a U.S. Total Stock Market fund or an S&P 500 fund to an Emerging Markets Growth Fund. Just the phrase "emerging markets" should give you an idea why there is both the potential for significant returns, and the risk of lagging mature markets.

That emerging market fund didn't have such high returns because of the expense ratio, it had high returns because for a while emerging markets were hot hot hot. They're not anymore. But maybe they will be again? That's the risk, you don't know.

matchewed

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Re: Why are we so averse to high expense ratios?
« Reply #16 on: July 08, 2014, 05:49:32 AM »
My work 401k is as follows

Bond Funds: 5%
ER- 0.63% (Return minus ER since inception - 7.59%)
and ER- 0.50% (RSI - 10.25%)

Income and Growth: 10%
ER- 0.29% (RSI - 16.17%)
ER - 0.74%? (Prospectus wouldn't load) (RSI - 10.11%?)

Target Date - 5%
ER - 0.47% (RSI - 13.86%)

Large Growth - 5%
ER - 1.2% (RSI - 16.39%)

Indices - 35%
ER - 0.05% (RSI - 7.35%)
ER - 0.09% (RSI - 7.84%)
ER - 0.09% (RSI - 8.79%)

Emerging Markets Small Cap - 15%
ER - 0.72% (RSI - 12.05%)

Emerging Markets Mid Cap - 10%
ER - 1.01% (RSI - 13.96%)

Emerging Markets Large Cap - 15%
ER - 0.49% (RSI - 13.70%)
ER - 0.87% (RSI - 14.56%)


Remember that RSI isn't a good apples to apples comparison since the inception dates will all be different. It is much better to look at 10 or five year performance.

That being said. Standard advice. Investment Policy Statement, Asset Allocation that lets you sleep at night, minimize fees, use broad based index funds.

The fees just add up a great deal over time. To see an impact of fees you can go here. My quick check at someone who is 22, FIRE's at 45, and maximizes their 401k will have a difference of $42k in fees between choosing a fund with .05% expense ratio and one with a .75% expense ratio. The difference between .05% and 1.66% is even greater, $92k over the same time frame. This isn't small money we're talking about here.

PloddingInsight

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Re: Why are we so averse to high expense ratios?
« Reply #17 on: July 08, 2014, 05:57:06 AM »
Hello Mustachians!

I've been an active visitor on this site for just over a week - I've already learned a ton and look forward to learning more as I get specific questions answered.  A quick about me before getting into my first Ask a Mustachian -- I'm a 22 y/o college grad and I just started my working career as an engineer.  I've been fanatically educating myself about investing and only recently learned the importance of extreme saving upon visiting this site -- thank goodness I've only been in the working world a few weeks!

Now to the good stuff:

I've seen plenty of articles online and wisdom here about the necessity of investing in a low cost index fund to avoid expense ratios that will subtract a major percentage of your portfolio over time.  Here's one:  http://www.nytimes.com/2014/03/02/your-money/give-fees-an-inch-and-theyll-take-a-mile.html?_r=0

Obviously, it would make sense to invest in a low cost index fund if we believed it would return the same amount as a high expense ratio one.  But, what I am seeing is that some high expense ratio funds are performing wonderfully on the 'hypothetical investment of $10,000 over 10 years'.  Specifically among my limited 401k options, DREGX (1.66%) and SKSEX (1.47%) have vastly outperformed low cost indices.  Even the Vanguard funds that are Vanguard high (say >0.20%), VGHCX (0.35%) and VGENX are dominating the passive funds.

There must be some aspect I am overlooking here and so I turn to you to straighten me out my fellow Mustachians and rationalize why I should invest in FSPNX (0.10%) and FSKTX (0.07%) instead!

garrett,

You have successfully identified some funds that beat the market in the past.  But your methodology (looking at the historical returns on the internet) will not help you identify funds that beat the market in the future.

I am reminded of the wisdom of Yogi Berra: "Buy a stock.  If it goes up, sell it.  If it goes down, don't buy it."

matchewed

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Re: Why are we so averse to high expense ratios?
« Reply #18 on: July 08, 2014, 05:58:50 AM »
DREGX should be compared to VEIEX. In the 10 year analysis VEIEX beats out DREGX. In the five year it flips. But that doesn't take into account any fees associated with it. Those fees can easily make the difference. Looking at the fund analyzer already mentioned, DREGX fails the 10 and five year check against VEIEX.

I hope you realize that fees kill performance and that you need to check similar assets with each other when deciding what funds to invest in. Good luck and keep up with questions as you come up with them.

JCfire

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Re: Why are we so averse to high expense ratios?
« Reply #19 on: July 08, 2014, 06:06:05 AM »
Hello Mustachians!

I've been an active visitor on this site for just over a week - I've already learned a ton and look forward to learning more as I get specific questions answered.  A quick about me before getting into my first Ask a Mustachian -- I'm a 22 y/o college grad and I just started my working career as an engineer.  I've been fanatically educating myself about investing and only recently learned the importance of extreme saving upon visiting this site -- thank goodness I've only been in the working world a few weeks!

Now to the good stuff:

I've seen plenty of articles online and wisdom here about the necessity of investing in a low cost index fund to avoid expense ratios that will subtract a major percentage of your portfolio over time.  Here's one:  http://www.nytimes.com/2014/03/02/your-money/give-fees-an-inch-and-theyll-take-a-mile.html?_r=0

Obviously, it would make sense to invest in a low cost index fund if we believed it would return the same amount as a high expense ratio one.  But, what I am seeing is that some high expense ratio funds are performing wonderfully on the 'hypothetical investment of $10,000 over 10 years'.  Specifically among my limited 401k options, DREGX (1.66%) and SKSEX (1.47%) have vastly outperformed low cost indices.  Even the Vanguard funds that are Vanguard high (say >0.20%), VGHCX (0.35%) and VGENX are dominating the passive funds.

There must be some aspect I am overlooking here and so I turn to you to straighten me out my fellow Mustachians and rationalize why I should invest in FSPNX (0.10%) and FSKTX (0.07%) instead!

Garrett -- the 401k options you're referring to are in different asset classes, which has an influence on their returns and also their expense ratios.  DREGX is an emerging market equity fund.  For the last 5, 10, and 20 years, emerging market equities have significantly outperformed developed market equities, and they have also experienced much higher volatility (in US Dollar denominated terms).  So with that asset class you're taking on more risk for the chance of higher returns.  The fund you mentioned is in the top 5% of its peer group in terms of 5 year trailing returns.  However, long-term studies suggest that trailing peer group rankings are not a good predictive indicator of future outperformance in general.

The other fund is involved in small-cap value equities in the U.S., and is also in the top 5% of its peer group in terms of 5-year trailing returns, so the same caveats apply.

You are looking at past returns to predict future results, which is a bit of a dangerous game when it comes to individual fund managers.  There's no evidence that it works, and quite a bit of evidence that it doesn't.  In my view, you shouldn't expect these two funds to be top 5% performers in their asset class over the next 5 years, and there's about a 50% chance that they'll trail more than half of their peers over that time period.  There's a lot of uncertainty there.  There's no uncertainty in the fee difference between these funds and a domestic index fund, and there very little uncertainty about which investment carries more volatility and risk, especially in US Dollar terms -- you should realize that when you buy EM equities you are also taking on currency risk, since your investments are being made in those emerging markets' currencies.

Caveat emptor, and best of luck.

JCfire

Middlesbrough

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Re: Why are we so averse to high expense ratios?
« Reply #20 on: July 08, 2014, 01:27:31 PM »
My work 401k is as follows

Bond Funds: 5%
ER- 0.63% (Return minus ER since inception - 7.59%)
and ER- 0.50% (RSI - 10.25%)

Income and Growth: 10%
ER- 0.29% (RSI - 16.17%)
ER - 0.74%? (Prospectus wouldn't load) (RSI - 10.11%?)

Target Date - 5%
ER - 0.47% (RSI - 13.86%)

Large Growth - 5%
ER - 1.2% (RSI - 16.39%)

Indices - 35%
ER - 0.05% (RSI - 7.35%)
ER - 0.09% (RSI - 7.84%)
ER - 0.09% (RSI - 8.79%)

Emerging Markets Small Cap - 15%
ER - 0.72% (RSI - 12.05%)

Emerging Markets Mid Cap - 10%
ER - 1.01% (RSI - 13.96%)

Emerging Markets Large Cap - 15%
ER - 0.49% (RSI - 13.70%)
ER - 0.87% (RSI - 14.56%)


Remember that RSI isn't a good apples to apples comparison since the inception dates will all be different. It is much better to look at 10 or five year performance.

That being said. Standard advice. Investment Policy Statement, Asset Allocation that lets you sleep at night, minimize fees, use broad based index funds.

The fees just add up a great deal over time. To see an impact of fees you can go here. My quick check at someone who is 22, FIRE's at 45, and maximizes their 401k will have a difference of $42k in fees between choosing a fund with .05% expense ratio and one with a .75% expense ratio. The difference between .05% and 1.66% is even greater, $92k over the same time frame. This isn't small money we're talking about here.
True the RSI is a moving target, but the only one that has been stared in the last 10 years is the target date fund because I picked the furthest one out (2055) to expose myself to some of the mutual funds I cant hold directly from my mix available to me. When it comes to US companies they make up 50% of my portfolio and 70% or that is in passive indices. The emerging markets portion is basically non-US companies (Europe, Australia, Asia, Middle East, etc.) Yes that portion isn't doing as well now, but I want exposure to as many markets as possible. I don't have access to passive foriegn indices, so I have some higher ER's. I am fine with that, others are not.

matchewed

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Re: Why are we so averse to high expense ratios?
« Reply #21 on: July 08, 2014, 01:48:37 PM »
My work 401k is as follows

Bond Funds: 5%
ER- 0.63% (Return minus ER since inception - 7.59%)
and ER- 0.50% (RSI - 10.25%)

Income and Growth: 10%
ER- 0.29% (RSI - 16.17%)
ER - 0.74%? (Prospectus wouldn't load) (RSI - 10.11%?)

Target Date - 5%
ER - 0.47% (RSI - 13.86%)

Large Growth - 5%
ER - 1.2% (RSI - 16.39%)

Indices - 35%
ER - 0.05% (RSI - 7.35%)
ER - 0.09% (RSI - 7.84%)
ER - 0.09% (RSI - 8.79%)

Emerging Markets Small Cap - 15%
ER - 0.72% (RSI - 12.05%)

Emerging Markets Mid Cap - 10%
ER - 1.01% (RSI - 13.96%)

Emerging Markets Large Cap - 15%
ER - 0.49% (RSI - 13.70%)
ER - 0.87% (RSI - 14.56%)


Remember that RSI isn't a good apples to apples comparison since the inception dates will all be different. It is much better to look at 10 or five year performance.

That being said. Standard advice. Investment Policy Statement, Asset Allocation that lets you sleep at night, minimize fees, use broad based index funds.

The fees just add up a great deal over time. To see an impact of fees you can go here. My quick check at someone who is 22, FIRE's at 45, and maximizes their 401k will have a difference of $42k in fees between choosing a fund with .05% expense ratio and one with a .75% expense ratio. The difference between .05% and 1.66% is even greater, $92k over the same time frame. This isn't small money we're talking about here.
True the RSI is a moving target, but the only one that has been stared in the last 10 years is the target date fund because I picked the furthest one out (2055) to expose myself to some of the mutual funds I cant hold directly from my mix available to me. When it comes to US companies they make up 50% of my portfolio and 70% or that is in passive indices. The emerging markets portion is basically non-US companies (Europe, Australia, Asia, Middle East, etc.) Yes that portion isn't doing as well now, but I want exposure to as many markets as possible. I don't have access to passive foriegn indices, so I have some higher ER's. I am fine with that, others are not.

Bolded for emphasis. I was just pointing out to your post that RSI is a bad measurement. If the 10 year analysis isn't available then use the five year. The downside to that is that the market has been on a tear for five years. I would avoid any actively managed fund that has only begun in that time frame as they would have been stupid not to look good for the last five years. The rest of my post was meant for the OP. You're welcome to invest in anything you want. :)