NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action.
Before I show you why low investment costs are so important let us define the expense ratio of a mutual fund.
Depending on the type of fund, operating expenses vary widely. The largest component of operating expenses is the fee paid to a fund’s investment manager/advisor. Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees. Some funds have a marketing cost referred to as a 12b-1 fee, which would also be included in operating expenses. A fund’s trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio.
In simple terms lets say you invest $100 in stock mutual fund. If it goes up 10% and has an expense ratio of 1.6% you make $8.4 not $10. If the expense ratio was just 0.2% you would make $9.8. Keep in mind that this does not take into account the costs of buying or selling or the higher taxes that you may pay in an active fund. I will talk more about those in future posts.
The extra $1.40 sure is nice but lets take a look at the effect over time. We will start with $10,000 and assume a 10% return per year for the next 30 years. One fund returns a net of 8.4% per year and the other returns 9.8% per year. After 30 years would would have either $165,223 or $112,429. A difference of almost $53,000!