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Expense ratio: Keeping more of what you earn

How expenses can take a toll on your investment strategy if you’re not considering them in your decisions.

By Wei-Yin Hu, Ph.D., Vice President, Financial Research

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Last updated: September 26, 2022 |

Article published: February 28, 2022

When you buy a new car or even an airline ticket, you probably shop around and compare prices. Why not? Costs matter. The less you pay, the more you get to keep.

If you can fly from Atlanta to New York for $100 less on Airline A than Airline B with nearly the same arrival time, wouldn’t you rather keep the money for yourself? Or if one car dealer will sell you the exact make and model vehicle for $1,000 less, you’d probably buy the car from them.

In everyday life – and in investing – there are opportunities to cut costs, often with nearly the same outcomes.

What does a fund cost?

When investing, costs matter too. An investment fund charges an annual fee called an expense ratio. Expense ratios can drag down your returns because the fund charges you a percentage of your investment. For example, if you invest in a mutual fund with a 1% expense ratio, you’ll pay the fund $10 per year for every $1,000 invested.

Let’s consider an example. Say there are two bicycle teams competing in the Tour de France – a bike race of 2,000+ miles in only 23 days. One team must ride through France carrying 35-pound backpacks, while the other riders carry nothing. Which team do you think is likely to have a better average time?

You could think of a fund’s fees like those backpacks – they weigh you down and reduce your total return over the long term. The bottom line?

The less you pay for a fund, the more money you can keep in your account.

Our investment approach

At Edelman Financial Engines, we are careful to look for investments that are low-cost. When we select the recommended funds for your portfolio, we pay attention to each fund’s risk and forward-looking return opportunities.

The expense ratio can be a more consistent predictor of future returns than past performance. We take this very seriously because a fund manager’s stock picks may benefit from good luck or bad luck, but you can be sure you’re going to pay the expense ratio, in good and bad markets.

Transaction costs are another cost-related factor that we pay attention to. Many mutual fund managers frequently buy and sell securities throughout the year. The average mutual fund has a 63% turnover rate, according to Morningstar, meaning the typical fund sells two out of three of its holdings every year. Every time a fund manager buys or sells a stock, it faces some trading costs.

In addition, high turnover can cause you to pay taxes on some of those funds’ transactions, even if the fund overall lost money.

What the expense ratio can mean to your bottom line

Picking between a fund with a low expense ratio of .05% versus one with a higher expense ratio of 1% may not seem like a lot, but it can really add up over time.

For example, suppose you have $10,000 to invest and are choosing among stock funds that might on average earn 8% per year. After expenses, the cheaper fund could increase your investment to $46,180 after 20 years (assuming it earns exactly 8% per year every year before expenses). The more expensive fund would increase to only $38,700 (see chart below).

That means the lower-expense fund could net you 19% more money for retirement (and that’s 19% less money in a fund manager’s pocket).

graph depicting two funds and investors earn 19% more money over 20 years in lower-expense fund

One part of the investment strategy

To be clear, we are not just choosing the lowest-cost investment vehicle. Expenses are one of the many things we analyze including risk, asset class diversification and manager performance. Yet, it is a factor because costs matter.

Wouldn’t you rather keep more of what your investments earn?

If you’re interested in working with one of our independent financial advisors and learning more about our investment approach, contact us today.

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