Low Costs: The Key to Funds’ Long-Term Success
Investors have countless mutual funds and exchange-traded funds ETFs) from which to choose, but the task can be made much easier by focusing on one item: the expense ratio. Over time, funds with the lowest expense ratios tend to deliver the best performance. As a result, investors can greatly increase their odds of success by focusing on the lowest-fee funds.
What is an Expense Ratio?
The expense ratio is a cost separate from the “load,” which is the up-front commission the investor pays to the broker or financial advisor. Simply put, the expense ratio is the cash the fund companies take out of every fund throughout the course of the year in order to offset their costs and make a profit. The average domestic taxable bond fund has an expense ratio of a little over 1.0%, while the average international and high-yield bond fund each checks in with an expense ratio of about 1.35%. Since the deduction of this fee is invisible – in other words, you don’t have to write a check – its true impact can be lost on investors.
How Does the Expense Ratio Affect Your Return?
Since it comes right off the top, the expense ratio reduces the rate of return earned by a fund’s portfolio. For instance, if a fund with a 1% expense ratio owns securities that produce a total return of 5% in a given year, the investor will see a return of 4%.
This may not seem like much, but over time it adds up. Most investors are aware of the power of compounding in generating wealth over the long term. Think of the expense ratio as compounding in reverse – over a long-term period, losing 1% to fees every year can take a big chunk out of your return.
The fee is particularly detrimental in today’s low-rate environment. While a 1% fee is less noticeable when yields are high, this same fee takes a much greater percentage of investors’ total return when the fund is only able to invest in securities that pay 3-4%. Worse still, the presence of the fee may tempt the manager to take on added risk just to stay even with the benchmark – which can be a surprise for investors when the bond market turns south.
Why Choose Funds with the Lowest Expense Ratios?
"If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds." – Russell Kinnell, Morningstar's director of mutual fund research.
Numerous studies have shown that over the long run, higher mutual fund fees lead to lower returns for investors. And the longer you hold, the greater the impact. The financial planning firm Fisher Financial Strategies calculated the impact of fees on long-term returns, and the results were striking. They assume $100,000 invested in a mutual fund that earns an average annual return of 8%. All else equal but fees, a fund with an expense ratio of 0.2% would have grown to $212,000 at the end of the first 10-year period, while a fund with an expense ratio of 2.0% only would have grown to $176,000. After 20 years, the difference is $448,000 versus $311,000, and after 30 years it’s $948,000 versus $549,000. In other words, the investor who chose the high-fee fund would have lost nearly $400,000 over a 30-year period. This is an extreme example for bond investors, since most funds don’t charge 2%, but even with a fee of 1% an investor would finish the 30-year period with $744,000, nearly $200,000 less than if he or she had chosen the fund with the lower expense ratio.
What Are You Paying For?
The only reason to invest in a fund with higher fees would be if it consistently beat the market over the full period. Unfortunately, that rarely occurs. Even the best money managers underperform fairly frequently, and these shortfalls can often be dramatic. The question then, is why pay more for inconsistent results when you can invest in an index fund with lower fees and the assurance that your investment will keep pace with the market?
The Bottom Line
Since fees are the most important determinant of long-term performance for mutual funds and ETFs, begin your search by looking at the expense ratio. Just as a shopper wouldn’t pay $5 for a gallon of milk when the store across the street is selling the same product for $3, neither should an investor settle for a fund with a high expense ratio.