High mutual fund costs have historically acted as a drag on performance, while lower costs have translated into better returns over the long run.  Vanguard has this illuminating article on the costs of investing through Fund Managers of various kinds.

You can't control the economy. You can't control the financial markets. And you can't control the performance of your mutual funds.

But there's one very important thing over which you do have some control: the amount of money you pay to invest. Ultimately, mutual fund costs can have a big effect on your net returns over the long run.

When you invest in a mutual fund, you're periodically charged a fee that is a percentage of your fund's assets. The higher a fund's expense ratio, generally speaking, the less money it's able to pass on to investors. All else being equal, high costs act as a drag on fund performance, while lower costs have historically gone hand in hand with better long-term net returns.

Here's evidence: In a 2004 study, independent research firm Standard & Poor's looked at historical net performance of almost 17,000 U.S. stock funds, and concluded that over both short and long periods, funds with below-average expenses performed better than their higher-cost competitors in eight out of nine investment style categories. (For more information on the S&P study, see the Notes section at the bottom of this page.)

A tale of two funds

Consider two hypothetical mutual funds. They're identical in every respect except one: Fund A has an expense ratio of 1.3%, meaning you'd pay $130 each year for every $10,000 you invest. Fund B, on the other hand, has an expense ratio of just 0.3% ($30 for every $10,000 invested).

If you were to invest $25,000 in each fund and assume an average annual return of 8%, after 20 years the two funds wouldn't be so "identical" after all. Even though both funds invested in the same securities and saw the same annual return, Fund B's net return would eventually be almost $20,000 higher than Fund A's, simply because of its lower costs.

Note: This hypothetical illustration does not represent the return or expense ratio of any particular investment.

If you're still not convinced that mutual fund costs matter, ask yourself whether you'd really turn your back on $20,000.

Indexing: A powerful way to keep your costs low

"A very compelling performance record"

The case for investing in index funds—funds that attempt to match particular market benchmarks, such as the S&P 500 Index—is compelling, especially when you consider the cost factor.

Index funds typically have lower operating costs than actively managed funds. That's largely because actively managed funds buy and sell securities frequently in an attempt to beat the market, which requires ongoing research and high portfolio turnover. Index funds, by contrast, use a passive, market-tracking approach, which helps keep their costs down and gives them a built-in head start in the performance "race."

A recent study by Vanguard's Investment Counseling & Research group, using data provided by Morningstar Inc., confirmed that the average index fund boasted lower expense ratios than its actively managed counterparts in every major fund category as of December 31, 2006. Not surprisingly, the same report also found that over longer periods a majority of actively managed funds failed to beat a broad market benchmark: From 1996 to 2006, a representative broad market index (the Dow Jones Wilshire 5000 Composite Index) bested the 10-year performance records of a majority of active fund managers.

The illustration below demonstrates how the "cost drag" of investing in a fund with higher expenses can impede your net returns, while an index fund's cost advantage may compound to your advantage over time.

From the day Vanguard began doing business, we've had a reputation as a low-cost leader in the investment and financial-services industry, and our funds have a track record of keeping costs low: In 2006, the average expense ratio for Vanguard funds was 0.21%, or $21 annually on a $10,000 account. That's less than one-sixth the industry average of 1.27%, according to data from research company Lipper Inc. That kind of cost advantage can add up substantially over time, and it's a record few of our competitors can match.

Here's how to be a price-smart investor:

• Learn about expense ratios and other costs.
• Compare fund costs before investing.
• Find out how Vanguard offers you exceptional value.

To learn more about using indexing's built-in head start to your advantage, listen to our Plain Talk on Investing™ podcast How index funds can work for you. You can also read The power of indexing from our Plain Talk Library, or view price and performance information for all Vanguard funds.