How Mutual Fund Expense Ratios Work

The other day, while perusing the Bogleheads investing forum, I ran across a misunderstanding of how mutual fund expense ratios work.

In short, someone was holding three different all-in-one mutual funds and was thinking of combining them all into one to avoid “avoid paying the expense ratios” on two of them.

As it turns out, these were three very similar funds with slightly different time horizons (targeting retirement in 2040, 2045, and 2050) and nearly identical expense ratios — 0.22%, 0.21%, and 0.22%, respectively.

So yes, I can see the attraction of reducing from three funds to one. I’m not sure of the exact composition of these funds, but I’d be surprised if putting all your money in the 2045 would be all that different from splitting it between the three.

But as to the issue of cost savings… The comment about avoiding expense ratios on two of the funds betrays a fundamental misunderstanding about what expense ratios are and how they actually work.

For starters, let’s define the term. The expense ratio is a measure of the costs associated with running a mutual fund. It’s calculated annually by dividing the total cost of running the fund by the assets under management.

These operating expenses are taken directly from the funds assets, thereby reducing your returns. Thus, there’s no line item associated with the ER, but the costs are very real. Consider the following scenario…

Let’s say you have $100k in each of the three funds mentioned above. In that case, the expenses associated with your holdings would look something like this:

$100k in 2040 @ 0.22% = $220/year
$100k in 2045 @ 0.21% = $210/year
$100k in 2050 @ 0.22% = $220/year

Thus, you’d incur costs of ca. $650 in the form of reduced returns in this (admittedly oversimplified) example.

Now let’s say that you combine all three funds into the 2045 version:

$300k in 2045 @ 0.21% = $630/year

As you can see, you’re not really avoiding expenses associated with the first and third funds. You’re just transferring them to second.

In this particular case, there’s a small benefit to moving the money to the 2045 fund since the ER on that fund is 0.01% less. But that’s essentially a rounding error and (IMHO) not worth reworking your portfolio to achieve.

So yes, you’d technically save a bit of money ($20/year on $300k in holdings) by combining your assets into the 2045 fund. But you wouldn’t avoid the expenses associated with the other two funds.

Again, this isn’t to say that combining balances is a bad idea. I’m a big fan of simplicity (my Lending Club dalliance notwithstanding), so I’m generally on board with streamlining your portfolio and would probably make the change myself.

One other point… The conversation in question centered on a 401(k), so there taxes weren’t a concern. In a non-retirement account, you’d want to consider the possible tax consequences before shuffling things around.

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