August 24, 2014

Expense Ratios: How Do They Impact Your Returns?

As brokers and ETF families continue to up the ante and push expense ratios lower, we as investors benefit. But just how important is it to choose a fund with a low expense ratio? After all, many ETFs and mutual funds charge less than 1% annually, so is it really a big deal? Working with a financial advisor could set you back further, with many charging between 1% and 2% of your assets each year.

Vanguard is widely known as the pioneer of low-cost indexing through mutual funds, launched its first ETF in 2001. Schwab was a bit later to the game, with many of their core funds launching in late 2009. Across the board, both companies are usually among the lowest (if not the lowest) in just about every segment they compete it. So does it make sense to chase the lowest expense ratios possible? When you consider that a fund charging around 1% annually (pretty common among mutual funds, less so among exchange-traded varieties) charges more than ten times more than one charging 0.10% or less, it's pretty dramatic! Yes, that's pretty simple math, but I don't think many appreciate just how much more a fund with an expensive ER costs.

Guy getting hot under the collar from his ETF's big expense ratios.
Within my company's 401(k), there are a lot of mutual funds charging around 0.75% annually. Some would be considered somewhat active, but for the most part, none venture too far from their passively-indexed counterparts. Many 401(k) participants have most or all of their savings in company plans, sometime leaving money there after moving on to a different company, or simply rolling everything into their new employer's plan.

Given that many folks often overlook the importance of examining the expenses of their investments (and I was curious just how much of a difference they make), I thought I'd put together a simple chart with returns from three hypothetical funds ranging from a 0.50% expense ratio up to 1% (although there are many that far exceed this!). For the low expense ETFs, I used two real growth funds: Vanguard's VUG and Schwab's SCHG. I didn't pick growth funds for any particular reason other than the fact that I just happened to notice a large cap growth mutual fund offered in my company's retirement plan had an expense ratio of around 0.75% (as did many of the others in the plan - some higher). Both VUG and SCHG offer very low expenses, at 0.09% and 0.07%. Technically, VUG is over 28% more expensive, but there's not much lower out there outside of a handful of funds that charge 0.04% or 0.05% (from the same two companies). Nevertheless, I wanted to see if such a small difference was important.

I assumed a continued annual growth rate of 10.4% a year, which is what the S&P 500 has returned over the past few decades. Whether or not those gains continue into the future is up for debate, but the end result of expense ratio is similar either way: they can eat up a massive chunk of your gains. So what do we see below?

Impact of High Expense Ratios on Long-Term Returns
Comparison of the impact of different expense ratios. Low-cost funds like VUG and SCHG help investors keep more of their money.

Some observations:
  • An fund and/or financial advisor taking 1% or more out of your assets each year better provide superior returns. All else being equal, you'd have 8.8% more money at the end of a decade investing in SCHG than in a fund charging 1%.
  • For those with long time horizons, going with the lowest expense ratio would have netted 28.9% more over 30 years and a gigantic additional 52.7% over 50!
  • The differences are less pronounced with a 0.75% expense ratio, but still eat up far too much over time for my comfort.
  • I'd say the 0.50% territory beings to look a bit more reasonable. I can't particularly think of any reason I'd invest in anything charging that much, but it's easier to stomach.
Realistically, any ETF that charges substantially less than half a percent annually is probably going to serve you well. Without seeing much (or any) evidence that active management can outperform passive in the long run, I don't foresee any scenario that would entice me to consider anything anywhere near a percent. For the record, the most expensive holding in my portfolio charges 0.20%.

A couple of takeaways:
  • Keep close track of retirement assets at former employers. If the company's plan is charging too much, make sure to roll over your investments into a self-directed account or possibly into your new employer's plan if it charges less . Neglecting old retirement accounts could be costing you.
  • As much as compounding returns (including reinvesting your dividends) can help you, the compounding effects of expenses work against you in the opposite direction.
  • Don't sweat small differences between ETFs with the lowest expenses. Even over 50 years, a 0.02% difference ads up to under a 1%. As long as you're looking at offerings generally on the low end, you'll be fine. If there's a fund you like that charges a little more because it's commission-free at a certain broker etc., don't worry about it.

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