Expense Ratios: A Major Determinant of Investment Return

 

Thinking about investing in a mutual fund, ETF, or hedge fund? You may have noticed these come with an “expense ratio.”

An expense ratio is the percentage of your investment you will pay to the money manager for establishing and modifying the items (stocks, bonds, etc.) in the fund over the course of the year. At specified time points, often the end of the year, the amount of money in the fund is multiplied by the expense ratio. This amount is then deducted from your money to pay the manager. This is the payment for managing your money.

There are two factors to consider when evaluating the expense ratio:

Factor 1: The expense ratio should be lower the less the manager needs to do. This first factor is obvious. If the fund manager simply rebalances the fund once a quarter, there should be a minimal fee. If fund manager engages in active trading or research, then it may be reasonable to compensate them for the additional effort.

Factor 2: The expense ratio should be lower if the expected return is lower. The second factor is often overlooked. Some funds have relatively high expense ratios, but fail to outperform a passively managed fund. In these cases, the higher expense ratio detracts from the overall return. If there is a high expense ratio, the long-term performance of the fund should be examined to ensure the extra cost provides an outsized return.

Four scenarios are shown below as examples. A 10% annual return is assumed for the S&P 500. A $100,000 initial investment is assumed. Yearly investments of $20,000 are assumed. A 20 year investment timeline is assumed. The Excel Future Value function (FV) is readily available to investors and was used for this article. The FV column shows the amount of money you would have at the end of 20 years, expressed in today’s terms.

Scenario A: This is the return from a passively managed S&P 500 index fund. The expense ratio is usually minimal for this type of fund. A 0.02% per year expense ratio is assumed for calculations. An initial 100k investment, with yearly investments of 20k yields 1.8 million dollars in 20 years.

The line in the table just below the index fund, labeled “Self managed S&P index” shows you’d have an extra 5k at the end of 20 years if you built an S&P 500 index yourself and paid no expense ratio. Of course, building your own S&P index fund would be difficult (if not impossible) to construct and manage, but you could pick a few of the best stocks from the S&P 500 if you knew how to value companies.

Scenario B: This is the return from an actively managed fund that beats the S&P performance by 2% but has a 2% expense ratio. In this example, the higher expense ratio cancels the benefit from the higher return. Not surprisingly, the 1.8 million dollars at the end of the 20 years is nearly identical to the passively managed fund. The slightly higher return of Scenario 2 is due to the lack of the 0.02% expense ratio associated with the S&P index fund. Of course, more money is better, but often the actively managed Scenario B funds fail to outperform the S&P 500 index. Will you pick the right actively managed fund?

Scenario C: This is the return from an actively managed fund that has the same return 10% return as the S&P 500, but has a 2% expense ratio. Over 20 years, you’d be down over 400k relative to the passively managed fund.

Scenario D: This is the ideal situation. You’ve selected a fund that handily beats the S&P 500 return, even with the 2% expense ratio. The 20% return is difficult to consistently achieve, but has been done. The 2% expense ratio is clearly worth the nearly 4 million dollar increase in the size of the fund at the end of 20 years. Scenario D is an oversimplification, as there is often a performance fee for these actively managed fund. Managers often receive a share of the profits from the outperformance. If you pick the right fund, you might be in for handsome returns. However, picking the right fund can be difficult.

Bottom line: Make sure the expense ratio is matched to the return. Also be sure the returns have been consistent over many years. Finally, take a look at the fund’s portfolio. Some contain unproven firms that have yet to show a profit. An educated investor would look at the financials of the companies included in the fund.

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