Expense Ratios – A Hidden Portfolio Drag
Cost is one of the few areas that can be controlled when investing. There is a semi-hidden cost called the expense ratio in all mutual funds and electronically trades funds (ETFs) that can have a big impact on your long-term investment results. An expense ratio (ER) is an embedded cost that covers the internal operations of the fund. It is not explicit on investment statements and usually overlooked by investors. The ER is usually expressed in terms of a percentage, such as 0.2%. This means that for every $10,000 invested, the internal expenses to operate that fund are $20. What costs does the expense ratio cover? For index funds, this fee covers the cost of subscribing to an index and transactions costs for buying and selling investments tracking that index. For actively-managed funds, ER costs also include research and salary costs associated with trying to outperform the market.
Actively Managed Funds vs. Index Based Funds Historically, actively-managed funds have had higher expense ratios than index-based funds (historically 1.0% for active funds vs 0.1% for index-based funds). This difference of 0.9% is a significantly higher expense drag. In order for this increased expense drag to be worthwhile, stock picking in an actively-managed fund has to beat the market by 0.9% to even match an index-based fund. On average, studies have shown this does not happen and costs investors money.
Are All Index Funds Created Equal? – No The S&P 500 Index fund tracks the 500 biggest companies in the US. Most S&P500 index funds have extremely low internal costs, such as the Schwab S&P500 fund (SWPPX) with 0.03% expense ratio. This is $3 of expenses for every $10,000 invested. In contrast, the Rydex S&P500 C share (RYSYX) with an expense ratio of 2.33%, or $233 for every $10,000 invested, is an example of a high-cost index fund. Holding the same basket of securities, owners of the Rydex fund solely pay for higher operating and advisory costs.
How To Find Out Your Investment Expenses? A simple Google search of the mutual fund or ETF symbol will show the embedded expenses on a particular fund. If you want even more information, we frequently use Morningstar here at BPC Advisors to look up the internal holdings of a mutual fund. Analyzing investment costs is something we evaluate as a part of all investment and financial planning proposals.
In summary, it is worthwhile understanding your total investment costs. With expense ratios, you generally get what you DON’T pay for.