Investments

Expense Ratios Matter

Recently, I was talking about mutual funds with a friend of mine. She was asking me about her Roth and, although the questions weren’t related to fees associated with the fund, this caused major concern for me since the fund she’s invested in has a hefty .85% expense ratio.  These fees can quickly erode any capital gains so it’s important to be mindful of this when choosing what to invest in.

The problem is that the fees and expenses associated with investing are so well hidden.  Unless you take the time to research the funds you have access to, you don’t realize how much it’s costing you. This is because firms deduct the fees from any capital gains (or include it in the losses), rather than specifically list it on your quarterly statement. I consider myself to be fairly financially savvy and even I don’t know the actual dollar amount I paid in fees in the last year.

Most concerning are the options available to us in our 401(k) plans.  I know mine are full of mutual funds with high expense ratios. (As a side note, this can be found in the Annual Fee Disclosure Statement that your employer or plan administrator should make available to you.) The expense ratios range from 0% (for company stock) up to .88% (for a small cap fund). Fortunately, an S&P 500 fund is available for me to invest in, with an expense ratio of only .05%.

.05% and .88% is a huge range. This means that for every $1000 I have invested in the fund, I pay only $.50 in annual fees vs $8.80 with the more expensive fund. With a more expensive fund, you need a much higher rate of return for your account balance to grow. To illustrate, here’s what the expense looks like in actual numbers.

Assuming you invest a one-time lump sum of $10,000 and the annual rate of return is 8%:

Expense Ratios

 

There’s a huge variance between an index fund at .05% and a managed fund at 1% — more than $7,000!  And that’s just over 20 years.  It gets worse if the timeframe is longer.

Yes, the funds are expensive because they’re managed (which assumes the fund manager is making the correct choices to ensure the best performance and minimize any losses), whereas the S&P 500 index fund I have my money invested in is not actively managed. But my opinion is that that index fund is so well diversified that there’s no need for it to be actively managed. There’s no reason that the holdings should change frequently since the fund can easily handle any shocks in a specific sector during a certain timeframe.

That being said, I think it’s important to invest in various index funds, namely a Total US Stock Market fund and a Total International Stock Market fund.  This further diversifies your portfolio while keeping the fees low. I don’t have these options available in my 401(k) but I do invest in them in my Rollover IRA, Roth IRA, and my taxable brokerage accounts.

There are many other factors to take into account as well (i.e. load vs no load, Morningstar ratings, etc.) but I won’t go into detail about those here.  For now, focus on keeping costs as low as possible where you can to ensure any market gains benefit you and not the fund managers.

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