How Expense Ratio Affects Long-Term Performance?

By Pinyo, on July 23, 2007

What is an expense ratio? It is a fee that mutual fund companies subtract from your investments each year for their services. Can that small fee have such a big impact? Yes, it’s possible for high expense ratio to eat up 50% of your gain — given enough time, high expense ratio mutual funds can cripple your investment growth potential.

There are many types of mutual funds, and many of them are excellent. And there are situations where mutual funds are more desirable than other types of investment. For example, they are great for diversification, easier for beginners, and easier to contribute regularly (i.e., some of them do not charge trade commission each time you add more money) — to name a few. That said, it is absolutely necessary to avoid mutual fund with high expense ratio. Here’s why:

Let’s take a look at $10,000 invested over 30 years with an average annualized gain of 10% (see chart below)

View spreadsheet

Now let’s assume these funds have the same return before expenses. If you invested in a fund with an expense ratio of 0.5% (typical for index funds), after 30 years you would have $152,203 and paid a total of $22,291 (or 12.8%) in expenses. Let’s look at another example. If you invested in an exotic mutual fund with an expense ratio of 2.5%, you would have only $87,550 and paid a whooping $86,944 (almost 50%) in expense fee. Ouch!

So high expense ration can really hurt your investment performance; therefore, you should consider the expense ratio carefully when investing in mutual funds. Alternatively, individual stocks and ETFs may make sense if you can invest enough money to overcome the trade commissions.

Here are a few basic rules I follow for investing with mutual funds.

• Invest in funds that do not charge Front-end Load — i.e., charge you before you can invest
• Invest in funds that do not charge Redemption Fee — i.e., charge you when you want to redeem your shares for money
• Invest in funds that do not charge Transaction Fee — i.e., charge you when you want to buy/sell shares.
• Invest in funds that have low expense ratio; preferably less than 1.0%. Index funds usually have expense ratio of 0.5% or less, making them the perfect candidates.
• Invest in funds with low portfolio turnover ratio. Lower turnover ratio means that the fund manager does less “buy & sell” and more “buy & hold”. This should make the fund more tax efficient and help you in the long term.
• Identify the right Asset Allocation mix based on investment goal, time horizon, and tolerance for risk.
• Diversify the investment portfolio among several funds. When selecting a specific fund, at least look at the Sector Allocation, holdings, PE, and past performance.
• Rebalance the investment portfolio at least once a year.

If you wish to learn more about mutual funds, here is a good article that will teach you the basics of investing in mutual funds.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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