The Importance of Expense Ratio

How much does an ETF costOne of the easiest forms of investing is via purchasing an ETF (Exchange Traded Fund). This investment form has first been introduced in 1993 and by today it became extremely popular. In 2015 there were over 4,000 different types of ETFs, therefore the choice is endless.

An ETF can suit almost all kind of investment needs from simple index ETFs (e.g. VTI, which represents the total US stock market) through sector ETFs (e.g. VFH, which represents the US financial sector) to some really wide spread investment vehicles (e.g. GIVE, which holds both US and global stocks, just as bonds, all focusing on environmental friendly and sustainable themes).

By buying an ETF, you’re basically buying a fund. Even Christ’s tomb was not guarded for free, and of course these funds also have some expenses. These costs can depend on various factors. For example an actively managed fund of course has higher expenses than a simple index ETF, How much the ETFs charge to their shareholders is called the expense ratio, which you can see as a percentage value. This also means that large funds usually have a smaller expense ratio, since their fixed expenses can be spread among a larger asset.

My personal favorite source to check the various details is Morningstar. If you check their webpage and search for an ETF, you can see the expense ratio in the upper right side of the screen. The below screenshot shows the details of Vanguard Total Stock Market ETF (VTI).

ETF expense ratio

Expense Ratio of VTI

This is one of the lowest expense ratio that you can find out there. But what would a couple of 0.1% extra mean for the overall return of your investment? On a short term probably not that much. But if you’re a long term investor, these seemingly little expenses can really eat up a lot from your returns.

Let’s say you invest EUR 10,000 every year in three different ETFs. The expense ratio of ETF1 is 0.1%, ETF2 is 0.3% and ETF3 is 0.8%. If we assume that each ETF has an annual return of 5%, this is how our balance will look like after 20 years:

Year 0.10% 0.30% 0.80%
1      10,000.00      10,000.00      10,000.00
2      20,490.00      20,470.00      20,420.00
3      31,494.01      31,432.09      31,277.64
4      43,037.22      42,909.40      42,591.30
5      55,146.04      54,926.14      54,380.14
6      67,848.20      67,507.67      66,664.10
7      81,172.76      80,680.53      79,463.99
8      95,150.22      94,472.51      92,801.48
9    109,812.58    108,912.72    106,699.14
10    125,193.40    124,031.62    121,180.51
11    141,327.88    139,861.11    136,270.09
12    158,252.94    156,434.58    151,993.43
13    176,007.34    173,787.00    168,377.16
14    194,631.70    191,954.99    185,449.00
15    214,168.65    210,976.88    203,237.86
16    234,662.91    230,892.79    221,773.84
17    256,161.40    251,744.75    241,088.35
18    278,713.30    273,576.75    261,214.06
19    302,370.26    296,434.86    282,185.05
20    327,186.40    320,367.30    304,036.82

Even though the expense ratio of all 3 ETFs are under 1%, that 0.7% difference between ETF1 and ETF3 means over EUR 23,000 after 20 years. This means that over two years of investment value has disappeared (at least from our returns) from ETF3.

Of course you should always compare apples with apples. Two US index ETFs (or ETFs for dividend investing) can be compared based on the expense ratio, but it doesn’t make sense to compare a US stock index ETF with an emerging market bond ETF. But next time you hesitate between two funds of the same category, definitely have a look at the expense ratio.

 

 

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Disclaimer: This post or any other information on the site is not intended to be and does not constitute financial advice or any other advice. I am solely sharing my idea, plan and progress on early retirement.

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6 thoughts on “The Importance of Expense Ratio

  1. Karl Steiner

    Totally agree that those seemingly small expense differences can really erode your returns over the long term. In addition, we should all be mindful that there is considerable evidence that higher costs are correlated with worse performance. Vanguard provides a good review of this at https://personal.vanguard.com/pdf/s296.pdf. Somewhat paradoxically, they found that the more you pay someone to manage your money, the worse the resulting returns for your investments. My suspicion is that higher fund costs spur fund managers to “do something” to justify all those extra fees. This inevitably results in the manager trying harder to beat the market, which is the proven way to almost guarantee underperforming the market. This gives us two reasons (cost erosion and worse performance) why real low cost index funds, not active funds masquerading as passive funds, are the best option for individual investors.

    Reply
    1. Roadrunner Post author

      Vanguard has some excellent funds with superb expense ratio. You can setup a great portfolio solely from their funds.
      I agree that most of the more expensive funds don’t worth their fee on a long term. However just today I came across a very interesting article about Medallion Fund that charges 5% on assets and 44% on profits. You can check out the returns in the article itself: https://www.bloomberg.com/news/articles/2016-11-21/how-renaissance-s-medallion-fund-became-finance-s-blackest-box

      Reply
  2. Mustard Seed Money

    One of my favorite features about Personal Capital is the ability to see the fees that you are paying. I quickly got rid of an inherited mutual fund when I saw how much the fees were eating up. One of the things that drives me crazy is when Dave Ramsey says fees don’t matter. He is definitely doing his followers a disservice when he says this as your article so nicely points out. Thanks for sharing!!!

    Reply

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