What is an expense ratio? It is a fee that a mutual fund or ETF subtracts from your total investment each year for their service. Can that small fee have such a significant impact on long-term investment performance? Is it better to invest in low-cost index funds? The answer is a resounding YES because a high expense ratio could eat up a lot of your gain over the course of 30 years.
How a 1% Expense Ratio Costs You $175,000
For this illustration, I am using Dinkytown’s Compare Investment Fees tool. I used a few, and this one is probably one of the best ones out there. Our assumption is as follow; an investor is contributing $500 a month to his IRA account over the course of 30 years at an annualized gain of 10% per year. I picked $500 a month because that adds up to $6,000, which is the current year IRA contribution limit (as of 2019).
The three expense ratios are:
- 0.2% Expense Ratio – typical if you invest in a diversified portfolio of mostly low-cost index funds
- 0.5% Expense Ratio – this is the benchmark amount provided by Personal Capital as the standard (see below)
- 1.2% Expense Ratio – this is on the expensive side, but it is still common in many 401(k) plans. This is also a convenient amount to show the cost of a 1% fee.
This is the result generated by the calculator:
The good news is that if you invest $500 over the course of 30 years, you could become a Millionaire! The bad news is that if you paid too much fees, a 1% increase in fees costs you $175,000 in returns.
So a high expense ratio can really hurt your investment performance; therefore, you should consider the expense ratio carefully when investing in mutual funds and ETFs.
But it gets even worse…
According to Chuck Jaffe, a long-time syndicated columnist and the host of “Money Life with Chuck Jaffe.”:
When market fits and starts come into play, say a fund gains 25 percent in January, stays up that much for 11 months … and then loses 15 points in December. The gain for the year is 10 percent, but the expenses for 10 months were paid on the 25 percent it was up, making the annual costs higher than your example.
Expenses are guaranteed, profits are not. If you invest $10,000 in a mutual fund, you will pay the expenses on that money whether the fund winds up going up or down. With fund costs having dropped dramatically, investors typically have low-cost options available, no matter what kind of fund they are looking to add to their portfolio. While costs should not be the sole deciding factor in an investment decision, investors need to remember that the money you don’t pay to a fund company is money that you get to keep in your own pocket.
Here are a few basic rules I follow for investing with mutual funds and ETFs.
- 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 sell your shares.
- Avoid funds that charge a transaction fee — i.e., charge you when you want to buy/sell shares.
- Invest in funds that have a low expense ratio; preferably less than 0.25%. Currently, the Fidelity 500 Index Fund (FXAIX) has an expense ratio of 0.015%, and Vanguard Index Fund has an expense ratio of 0.14% (VFINX).
- 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.
How to Check Expense Ratios for All Your Investments…For Free!
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 projected to pay through your retirement age.
In the screenshot, I adjusted my age to show 30 years until retirement. My current portfolio has a total expense ratio of 0.18% compared to the Benchmark of 0.5%. Even this tiny expense ratio of 0.18% costs 5% of earnings lost to fees over 30 years.
Here’s is a screenshot of what it looks like:
Expense Ratio of 1% may not sound like a lot of money, but over the course of 30 years, it could take away a significant chunk of your earnings. Be sure to use investment tools like Personal Capital to analyze your fees. It will show you the fee for each fund or ETF, and you can sort the list from the most expensive Expense Ratio to the least. Then you can sell the expensive ones in exchange for a similar fund at a much lower cost. Doing this alone will probably save you hundreds of thousands.
Pinyo Bhulipongsanon 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®.