How Expense Ratios Impact Your Investment Performance

By Pinyo, on May 8, 2011

What is an expense ratio? It is a fee that mutual fund companies subtract from your investments each year for their service. Can that small fee have such a big impact on long-term investment performance? The answer is a resounding YES — high expense ratio could eat up to 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 $10,000 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 fees. Ouch!

So a high expense ratio 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.

• Avoid funds that charge a front-end load — i.e., charge you before you can invest
• Avoid funds that charge a redemption fee — i.e., charge you when you want to redeem your shares for money
• Avoid funds that charge a transaction fee — i.e., charge you when you want to buy/sell shares.
• Invest in funds that have a lower 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 a lower portfolio turnover ratio. A 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, average capitalization, location, and past performance.
• Rebalance the investment portfolio at least once a year.

Here is an easy way to track your investment expenses

You can use Personal Capital to link to your investment accounts and use their Investment Checkup feature to analyze your investment expense. It will provide you with valuable information, such as, how much you are paying yearly, what you are project to pay over the course of 20 years, let you identify your most expensive investments, etc. Here’s is a screen shot of what it looks like:

Reviewed and updated May 8, 2011.

Leave Your Comment (9 Comments)

1. Cory says:

   October 9, 2007 at 8:33 pm

   1% of $10,000 = $100. How can -$100/year = -thousands of dollars?

   Does the mutual fund charge 1%/month? Or am I missing something?

   Sincerely,

   Cory

   *I already receive regular email from Moolanomy thanks.

   Reply
2. Pinyo says:

   October 9, 2007 at 9:07 pm

   @Cory – thank you for your question. The problem is that mutual funds don’t charge the expense on just your contribution — they charge 1% on the entire amount (contribution plus growth).

   For example, if you have $55,000 after you invested the initial $10,000 for 20 years, you will be charged $550 (not $100).

   I hope that clears it up.

   Reply
3. B says:

   April 8, 2009 at 3:15 pm

   Why do the values in the far right column grow by 7.25% if the remainder after taking out the 2.5% is 7.5%?

   Reply
4. Pinyo says:

   April 8, 2009 at 3:35 pm

   @B – I am not sure what you mean, so I shared the spreadsheet above here: http://spreadsheets.google.com.....hOZXfZxiYg

   Please take a look and let me know if you see what’s wrong.

   Reply
5. Kunal Pandya says:

   November 20, 2010 at 2:54 pm

   At the end of 10 years, why is it that you are subtracting 24782 from 25937 to get the amount less? What about the fees he paid in his 1st year, 2nd year and so forth? Shouldn’t the amount less at the end of 10 years take all those fees into consideration since these fees are charged annually? Please let me know.

   thanks

   Reply
6. Ken Faulkenberry says:

   May 11, 2011 at 9:15 pm

   Pinyo – I appreciate the way you take an important concept, provide the data to make your point, and most importantly present solid solutions or rules to follow. Some people need mutual funds for the reasons you outline, however, most investors should abandon mutual funds and only invest in stocks and ETFs. This greatly mitigates the expense ratio assualt on returns.
   Another piece of great advice is “identify the right asset allocation mix based on investment goal, time horizon, and tolerance for risk”. I would just add “Valuations” as another consideration of asset allocation mix.

   Thanks again for another great article.

   Reply
7. gm bellanca says:

   March 4, 2012 at 4:08 pm

   I’ve got your 2011 & 2012 Quarterly Estimated Tax due dates article tacked to my wall, and this article is going to be tacked next to it. You rock.

   Reply
8. Pinyo says:

   March 5, 2012 at 12:15 am

   @Kunal – The numbers are cumulative, so year 10 already reflects all the expenses over all 10 years.

   @Ken and GM – Thank you.

   Reply
9. Bob B says:

   March 3, 2013 at 9:52 pm

   When I go to a website of a mutual fund provider and see their fund’s 1 thru 10 year return percentages is that before or after the management fees are deducted? If after then I am really indifferent between a low mgmt fee fund and a high mgmt fee fund as long as the percent return is the same? Thanks

   Reply