Why You Need to Look at Expense Ratios.
Updated: Feb 13, 2020
With a multitude of different funds in the market today, it is important to know more than just their past returns. Despite this, many people believe the fees in different mutual funds are extremely insignificant to their return.
Honestly, it makes sense. A one percent fee per year doesn’t seem that crazy. However, if we look over long periods of time, this is where the fees make their mark.
WHAT IS AN EXPENSE RATIO?
An expense ratio is the total percentage fee that mutual funds and exchange-traded funds charge to cover their expenses including administrative, advertising, and management costs. For example, if a fund has an expense ratio of 1%, that means that the fund will take 1% of the total assets in the fund each year to cover expenses.
HOW DOES THIS EFFECT YOU?
An expense ratio is what the fund will cost you per year. If you have an investment of $100,000 and the expense ratio is 1%, the fund will take $1,000 out of your account to pay for expenses every year. In short, with a 1% expense ratio, you will be making a net return of one percent less than the gross return of the fund every year, even before including your tax burden.
While this might not seem like a large burden, let’s see what happens after thirty years using this same example of a $100,000 investment with a 1% expense ratio. Also, let’s assume this fund is returning around 7% annually.
After 30 years, you would now have a portfolio totaling $761,225.50 before fees. However, this is not actually your funds true worth because a 1% fee was taken out each year. After these fees are taken out, you would actually now only have a portfolio totaling $574,349.12.
From just a 1% fee, your portfolio lost nearly $200,000 or a third of its value. Although the fee did not seem like much in the short-term, over the long-term the fee stops compound interest from coming into full effect.
WHERE TO GO FROM HERE
This does not mean funds with a high expense ratio is bad; however, you need to pay attention to them make sure that the additional expenses are worth the return. So, next time you are looking at a fund to invest in, don’t just look at the returns, but also at the fees to see how they affect the return.