How a Mutual Fund’s Expense Ratio Impacts Your Bottom Line

There are literally thousands of mutual funds out there and many of them claim to be diversified, low cost, low fee, etc. But if there’s one thing that has the most direct impact on a fund’s return, it’s the expense ratio(ER). When comparing similar funds, I primarily look at the expense ratios first and foremost. Most mutual funds have expense ratios varying from about 0.1% to almost 4%. With the abundance of low cost mutual funds available today, there is no reason to ever consider ER’s of 1% or higher.

Some of us might be stuck with certain options in 401k plans. But for everyone else, finding funds with low ER should be a priority. An expense ratio is what it costs an investment company to offer a mutual fund. Actively managed funds tend to have higher ER’s because the fund manager is constantly buying/selling stocks while passively managed funds are the exact opposite. They buy/sell very infrequently and require little active management.

Stock Market is a Zero Sum Game

The stock market is a zero sum game meaning that a participant’s gain or loss is exactly balanced by the losses or gains of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.

Every dollar made by one investor is a dollar lost by another investor. This is a fact. The brokerage fees and expense ratios actually make this a negative sum game, meaning most traders lose. In order to achieve returns like the 10% average annual return of the Dow Jones, investors need to look for the lowest cost funds.

Low Cost Funds

If some active fund managers win, then others must lose. The smart investor will not leave their returns up to chance. Investing in low cost index funds will always return close to the average rate of return for that particular index. Low cost index funds attempt to mimic the exact holdings of the index they follow. Let’s take a look at Vanguard’s 500 Index Fund(VFINX):

VFINX

  • Invests in 500 of the largest U.S. companies
  • Expense Ratio = 0.17%, 85% lower than average ER for similar funds
  • 10 year avg. annual return = 4.02% (Compared to S&P 500 return of 4.12%)
As a sophisticated investor, you want a diversified fund with broad market exposure at the lowest cost. With an actively managed fund, you could be giving up to 3% of your returns away every year. That is a ridiculous number.
No matter how an actively managed fund performs(even if it goes down), you pay a fee. So if the market is averaging 10%, your actively managed fund has to beat the market by 3% every single year to equal my returns with a low cost passively managed index fund. So if you don’t consider yourself lucky enough to consistently pick the correct active fund managers, the best you can hope for is the average market returns. That’s where index funds come in to save the day.

Expense Ratios Can Cost You Hundreds of Thousands

Here’s an example of how much impact a 2% ER fund can have:

Max has his 401k invested in a low cost 500 index fund with a 0.2% ER. James has his 401k invested in an actively managed fund with 1% ER. Over 40 years, let’s assume both funds have the same rate of return of 5% per year(before fees). In each case we start off with $0 and contribute a modest $10,000 to our 401k. Using a 401k calculator, we see that after 40 years:

Max’s 401k value, using a low cost 500 index fund: $1,205,868

James’ 401k value, using actively managed fund: $998,265


The conservative numbers shown above illustrate the impact of expense ratios. Imagine what the difference would be if you max out your 401k and contribute $5k annually to an IRA. Expense ratios can literally make a million dollar difference. I actively avoid high fee funds for this reason. Actively managed funds will never beat low cost passive index funds over extended periods of time. The indexes as a whole will probably go up and through smart investing like this, you can expect to see a nice return on your money.

Do you know what the fees are for your 401k funds? Do you invest in actively managed funds? If so, please explain why?

-PF Pro

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Hi, I'm Harry, the owner and head writer for Your PF Pro. I started this site back in 2011 in order to create a place where young professionals could come and get all of their financial questions answered. On the site, you'll find articles on everything from asset allocation for retirement to saving money at Chipotle! So enjoy..

Comments

  1. says

    I really liked this post. I do not have a 401k because I work for the governement and have a pension instead :)

    Have you considered investing in a REIT?

  2. says

    Pensions are tough on governments as we see now, because they guarantee a certain rate of return regardless of what the pension’s investment’s return. But for the employees, they are awesome! I’m definitely jealous :)

    I haven’t looked into REIT’s too much. I’ll take some time to research them but it seems odd that you can invest in a mutual fund that then invests in real estate. Kind of like the gold/precious metal funds, where you invest in a mutual fund that invests in a tangible asset. That just seems really odd to me.

Trackbacks

  1. [...] Fees and asset allocation are important factors to consider, but young investors need to focus on increasing their rate of savings.  Think about it like this.  When you’re fresh out of college, your retirement accounts are low, so every contribution you make will significantly increase the percentage of your total account.  After you’ve built up your accounts, each dollar that you put in will have less and less of an impact to the overall total value. [...]

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