Expense Ratios Revisited: Calculating the High Cost of High Costs

by Michael on Jul 31, 2013 · 1 comment

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At the risk of preaching to the choir, I’d like to discuss investment expenses and how they affect the growth of your portfolio.

The other day, I covered expense ratios — what they are and how they work. Today, we’ll be talking about why they matter.

As you’re likely aware, high expenses tend to dampen returns. But have you ever run the numbers to see how much of an impact they’ll have on the size of your nest egg? I have.

Running the numbers

Consider the case of a hypothetical investor who starts a new job straight out of college and works there for 40 years. Further assume that he starts out contributing $5k/year into a retirement account and increases his contributions by 3% annually.

For simplicity, we’ll further assume that he targets a classic 60/40 mix of stocks and bonds and winds up earning an 8.6% annualized return, on par with the historical average for this mix.

If he was able to invest with no costs whatsoever, his portfolio would grow to a little over $2.31M (in nominal terms) by retirement. But, of course, it’s not possible to zero out your costs entirely. So…

Instead, he targets a low cost mix of index funds — say, Vanguard’s Total Stock and Bond Market Index funds (VTSMX and VBMFX). At a blended average of 0.18% in expenses, his portfolio would grow to a little over $2.21M at retirement.

Note: Yes, you can do a bit better with Admiral shares or the ETF share class, but let’s just run with it… If anything, our estimate of the effects of overpaying will end up being a bit conservative.

In contrast, what if he instead held funds with expenses on par with the industry average? In this case, he’d be paying ca. 1% per year, and his portfolio would grow to just short of $1.81M at retirement.

In other words, a difference of 0.82% in expense ratios would mean that he’d have roughly $403k less at retirement. $403k!

Factoring in inflation

Of course, I’ve been ignoring the effects of inflation, so the results above are a bit distorted. Instead, lets’s assume that inflation ticks along at 3%/year over his working life. An oversimplification to be sure, but I don’t have a crystal ball.

In that case, the low cost portfolio would be worth $698k in real terms, whereas the average cost portfolio would be worth $571k. That’s still a whopping difference of $127k in today’s dollars. All thanks to a 0.82% difference in expense ratios.

What about active management?

But wait… Since higher expenses are often associated with active management, they might translate into better performance. Makes sense, right? That high paid manager must be doing something right to justify his/her salary. Well…

For starters, many active managers are what have been referred to as “closet indexers” — i.e., their holdings closely mirror those of the major indices and thus perform like an index fund, but with higher costs. Thus, they underperform.

And even for those that truly walk to the beat of a different drummer, long-term outperformance is rare. Sure, some managers will trounce the relevant indices for short periods of time, but they typically regress to the mean.

Consider the following…

At the end of 2012, 63.3% of the actively managed, large cap funds included in the S&P Indices vs. Active Funds (SPIVA) Scorecard had underperformed their benchmark (the S&P 500) over the preceding year. And that number grows to 86.5% when looking across the preceding three years.

In terms of actual performance, these funds averaged returns of 14.67% and 8.95% over the preceding one and three years. Not bad, right? Well, the S&P 500 returned 15.98% and 10.86% over the same periods.

In other words, when these funds underperform, they tend tend to do so by a considerable margin. 1-2% based on recent averages. In contrast, with low cost index funds, you’d be virtually guaranteed to hang within a hair of your benchmark.

The prospects of outperformance

But let’s say that you firmly believe that long-term outperformance is possible — and who am I to say that it’s not? In that case, just how confident are you that you can identify the truly brilliant managers in advance?

Are you confident enough to risk potentially severe underperformance in the event that you’re wrong? Remember what 0.82% did? Just think what 1-2% (or more) would do to your portfolio over the long run…

1 Jon @ MoneySmartGuides August 1, 2013 at 6:34 am

It’s easy to overlook expense ratios because you never get a bill for the charges. It’s hidden in the return of the fund. So while your might return 6% this year, if its expenses were lower, you would have returned more.

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