Why Expense Ratios Are Important To Investors

By Greg McFarlane | June 22, 2012 AAA
Why Expense Ratios Are Important To Investors

The most valuable pieces of advice ever shared regarding investing of any kind, in ascending order of importance:

1. Fundamental analysis is crucial. Technical analysis is akin to fortune telling by interpreting patterns in tea leaves.

2. It's not a game or a hobby. Spend hours researching an investment when others are spending minutes. Spend days when others are spending hours. Done right, you'll still enjoy a stupendous return on your time.

3. You make your money going in.

It's straightforward math, and easy to overlook or dismiss in its simplicity. An overpriced asset is that much harder to gain a return on than an underpriced or properly priced one. Wait for a real estate bubble (or, say, the hoopla surrounding a social networking site's much-anticipated initial public offering) to subside and then buy; your margin for error and potential for return should increase correspondingly.

SEE: A Guide To Investor Fees

The Price of Management
We're not talking about normal price fluctuations, here, or the inherent unpredictability that comes with almost any investment. Rather, we're looking at what's essentially a surcharge on the price of the investment, levied before you buy. For example, take two new cars with the same model, same color and same options. One dealer sells the first vehicle for $22,000, "out the door." The other sells the identical vehicle for $22,000, but with a $495 non-negotiable "advertising and marketing assessment." Do you need to be told to buy the former? It's like purchasing a residential air filter in Vancouver, Washington (and paying 8% state sales tax) instead of going across the river and buying the same thing in Portland (Oregon levies no sales tax).

This is how it goes with mutual funds, the financial product of choice for most casual and many sophisticated investors. While no two funds are indistinguishable, two similarly constituted funds can come with price tags that differ considerably. Why? Varying expense ratios.

It's understandable that a mutual fund's price costs more than the prices of its components. It costs money to create a fund. The fund has to be set up, registered and maintained. The firm that created it and that hired its managers has to be compensated. However, to what tune? The U.S. Securities & Exchange Commission (SEC) requires (and common sense recommends) that mutual fund issuers list each of their funds' annual operating expenses, breaking them down by category (e.g., management fees, distribution fees) and adding them together in an item called "total annual fund operating expenses" (alternatively, for our purposes and parlance, expense ratio). It's the premium you pay to the issuer on top of the price of the fund itself.

Mutual fund companies make it easy for you to comparison shop with regard to expense ratio. They tell you the minimum you'll lose before you purchase; if only people who manage other types of investments were that big on disclosure. If you think expense ratios are close to uniform, they aren't.

Take American Growth Fund, a fund issuer out of Denver. Its Class C Shares (AMRCX) have one of the largest expense ratios we could find. A staggering 5.68% of your investment goes toward paying the American Growth Fund manager(s) and other expenses, such as mailing out updates. Contrast that with Strategic Advisers' U.S. Opportunity II Fund (FUSPX). (If you've never heard of Strategic Advisers, it's a subsidiary of leviathan Fidelity Investments.) This particular fund is larger than the American Growth Fund's C shares by several orders of magnitude, but it's the expense ratio of 0.02% that gets a conscientious investor's attention.

SEE: Stop Paying High Mutual Fund Fees

Differences in Returns
The differences in expense ratios aren't just numbers in a column. They make a palpable impact on your bottom line. Say you want to invest $5000 in each of the two funds. The former fund acknowledges that you'll be out $284 before a single one of its components starts trading. Buy a position in the latter and you'll be out one dollar. Granted, expense ratios fluctuate from year to year and from fund to fund under the same issuer, but few people are willing to pay an extra $284 to take a seat at the blackjack table before the dealer even cuts the deck.

If the difference between a 5.68% expense ratio and a 0.02% expense ratio seems significant now, you should see it in a decade. Assume that each fund shows a nominal (pre-expense) 10% return, year in and year out. If you didn't take expense ratios into account, you'd figure the funds would be interchangeable.

However, if you did (as you should) look at expense ratios, the difference is vast and unmistakable. In over 10 years, that $5000 investment would turn into $7,632.13 when invested in a fund with a 5.68% expense ratio. Buy the fund with the .02% expense ratio and with the same nominal return, you'd pocket $12,945.15 (or 70% more). Compounding really is the most powerful force in the universe.

The Bottom Line
Look at components when you buy a mutual fund. Look at your own objectives, such as growth and income; however, never treat expense ratio as an afterthought. It might be the most underappreciated criterion in all of investing.

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