Expense Ratio

What is the expense ratio of a fund?

The expense ratio tells you what percentage of assets a mutual fund, index fund, orexchange-traded fund will take from you on an annual basis as a fee for services. For example, a 1% ratio will take $1 out of a fund account that has $100. 1% might not seem like much, but over many years that 1% can take a chunk much larger than 1% out of your investment.

Here's a good example of why big costs can lower your gains by a lot. Lets say you invest $10,000 into a fund with a ratio of 0.2% and another $10,000 into a fund with a ratio of 1.2%. After 40 years, if your returns for both are 8% annually before costs, your 1st fund has $201,000 and the 2nd fund has $138,000. Saving that extra 1% in expenses made you about 50% more money - $63,000! And that's assuming the returns are the same. In fact, studies have shown that high cost funds tend to do worse and the low cost funds tend to do better.

What is a reasonable percentage?

Expenses are the ultimate measure of how good the returns of a mutual fund, index fund, or exchange traded fund will be. In the investing world, you do not "get what you pay for." In fact, there's a lot of evidence to suggest the opposite! The more you pay for a fund, the less you get back. I don't like the idea of lining the pockets of already rich Wall Street brokers.

For me, 1% is high. I refuse to pay for any funds that have a expenses higher than 0.4%. There are too many good funds that will cost you around 0.2% to pay anything higher than 0.4%. The only place I may break that rule is for an international fund because I expect the costs to be higher.

I've been told that I'm picky by saying don't go above 0.4%. If you're investing outside of your 401k and you have a choice where to put the money, then I see no reason to pay more than 0.4%. However, sometimes you will have no choice, but to invest in something above 0.4%, its OK to go up to 1%.

Expect significantly lower expenses for an ETF (exchange-traded fund). Afterall, you have to pay a broker to buy the ETF for you while mutual and index funds generally don't charge a load fee - AKA "no load fund".

What do the expenses pay for?

You're paying for staffing and brokerage costs. The more that the fund reduces those, the smaller the expenses. If the fund requires many, high paid investment professionals to run, then your expense ratio will be higher. Why pay for an investment professional's new BMW when he or she does not provide the fund with any extra value?

Also, if the fund requires buying and selling stocks frequently - a high turnover rate - then the expense ratio will be higher. Furthermore, frequent buying and selling also increases your exposure to capital gains taxes. While not directly related to the fund’s expense ratio, it does add to the overall cost of investing in that fund.

Are the expenses worth it? Can “investment professionals” consistently beat the market?

Generally, no.

It is questionable whether most people - including the so-called experts - have any consistent skill at stock picking. At first glance, this might seem like a difficult notion to accept. If true, what does that say about the countless investment firms across America whose sole job is to pick winning stocks or funds? Are all of these people really just spinning their wheels each day in the ultimate Wall Street fool's errand? Actually, that might not be far from the truth.

In his book A Random Walk Down Wall Street, Burton G. Malkiel famously said "a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts."

In 1988, AutomaticFinances.com explains, the Wall Street Journal took this as a challenge and had its employees (acting as the monkeys) throw darts at a stock table, while investment experts picked stocks of their own. Six months later, the experts did indeed beat the "monkeys" in 61 out of 100 contests. They did, however, LOSE the other 39% of the time to completely random dart tosses.

Think back to earlier, when I showed you how a mere 1% reduction in fund expenses translated to $63,000 in your pocket. Are you willing to sacrifice those savings when the “experts” you’re paying lose to novices nearly 40% of the time?

I point this out not to degrade investment professionals, but to show you that their claims of expertise are not always well-founded. A doctor is probably the best example of someone with unquestionable, rock-solid expertise. They will perform surgeries, set broken bones, and diagnose complex illnesses more effectively than novices 100% of the time.

Fund managers would like you to believe they have doctor-like stock market expertise (to justify their fees) but the truth is that NO ONE does! Investing is simply too uncertain, and involves too many variables, for anyone to be that good.

What's the best way to keep expenses low?

Buy simple, general index funds instead of mutual funds. In fact, when you run the numbers, 80-90% of mutual funds lose to a basic all stock market index fund. The simpler the index, the cheaper it is to run and the more money that comes back to your pocket.

Index funds save you money by replacing fund managers with computers. Constant buying and selling is replaced by patient buying and holding - saving you not only fund fees, but capital gains taxes as well.

I recommend checking out what I consider to be the best way to invest money for ways to keep your expenses low and still get a good return on your money.

return from expense ratio to index funds

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