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)
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.
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.