Expense Ratios: Fees Destroying Your Fund Returns

Expense Ratios: Fees Destroying Your Fund Returns

Expense ratio fees from index funds and mutual funds and ETFs could be destroying your returns if you’re paying too much! Learn how you can save money on these fees!

If you’re interested in learning how to take control of your finances and start becoming an investor like Warren Buffett, check out my free PDF guide.

Expense ratios usually come with investing in diversified mutual funds like index funds or ETFs that contain a variety of assets and not just stocks. These fees are the total operational and management fees that cover the expenses of the fund manager in offering the fund.

These fees are usually calculated on an annual basis, reflecting the assets under management (AUM), and is usually disclosed on the fund’s prospectus and shareholder reports.

Generally, the lower the expense ratio fees the better! For some historical context behind the evolution of fees, retail investors like you and I used to have to pay way more in commission fees until very recently.

Mutual funds have been around since the 1920s and gained in a lot of popularity in the 1980s and 1990s. Many of our baby boomer parents invested in actively managed mutual funds that didn’t always get the best returns because of how high fee percentages were (Like 2-3% or more!)!

Jack Bogle of Vanguard invented index funds in the 1970s. Passive market index funds have gained in way more popularity in the last two decades and allowed everyday investors to save way more on fees (which are often less than 1%)! Simply tracking the market performance was a lot easier and a more profitable way to go for a lot of people when they buy into more passively tracked index funds and ETFs versus actively managed mutual funds.

In the past, way more mutual funds used to come with load fees aka initial purchase fees for buying into the fund. Nowadays there are a lot of funds that are considered no load or no transaction fees where you don’t have to pay anything up front to buy into the fund.

Another boon for retail investors is there’s been a lot of price transparency made publicly available on the internet and that’s led to brokerage firms reducing commission rates over time. The competition for investors accelerated so much that in the Fall of 2019, most popular brokerages slashed their commission fees to $0! A lot more people could then invest. Pretty sure this is part of why we’ve had such a huge influx of money being invested because we had less costly barriers to entry.

How are brokerage firms able to offer these funds with little to no fees? They charge fees on all kinds of other account and professional services. Some brokerage companies even do payment for order flow, which ends up tacking on extra costs on the bid and ask spread so the transaction is not completely “free” in that the final buy or sell price isn’t the best price for the retail investor. Hint: Charlie Munger doesn’t like companies that do this!

If you invested $10K into a fund and paid 0.5% in expense ratio fees over the course of a year, that’s $50 in fees compared with another fund that’s 0.05% is $5! You could save by investing in lower cost funds that give comparable yields and have similar asset allocations.

I love using analogies! I highlight some car analogies of how 2% in expense ratio fees over 30 years can equal a Bentley’s worth of money. Or 1% is the value of a Range Rover. 0.5% is a Tesla. 0.15% is a Honda Fit, while 0.03% is a Used 2006 Honda Civic! Between 2% and 0.03%, that’s a difference of almost $204,000!!! A whole lotta Beemers if you ask me!

Although I review a few practical examples, I’m not invested in them and this is not an endorsement of the following. I compare two similar-looking index funds based on the S&P 500 index in Fidelity and Vanguard and looking at their expense ratio fees, if they have any load or transaction fees, and if they have any minimums required to invest.

I’m not invested in these funds because they’re super diversified and invested in hundreds of stocks that I haven’t done the homework to understand all those stocks. If I invest in mutual funds, I’d only be in the kind that invests in maybe 10-15 assets so I can conduct my due diligence and learn if I like the assets the fund is invested in. And if I think this fund has more of a competitive advantage to earn superior returns.

Since I wouldn’t know what many funds are really invested in and it’s a big guessing game to me; I’d rather play it safer by investing in individual company stocks like how Warren Buffett and Charlie Munger do. For potential companies I’d like to own I’d do the research, evaluate if I think the company’s management has integrity, and what I calculate as the real valuation of stocks.

All of us are on the journey toward financial freedom, and I look forward to making more investor friends.

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