Low Expense Ratios – More Important for Your Investment Returns Than You Think

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Low expense ratiosEven small changes add up over time.
When looking for maximum investment returns from funds, most investors look for the best performing funds, and this is as it should be. But the second most important consideration is low expense ratios. The reason is simple – whatever you make in investment returns, you’ll give back through expenses, at least partially. The secret to…

When looking for maximum investment returns from funds, most investors look for the best performing funds, and this is as it should be. But the second most important consideration is low expense ratios.

The reason is simple – whatever you make in investment returns, you’ll give back through expenses, at least partially.

The secret to sound investing is to locate both the best-performing investments, and the lowest-cost way to hold and trade them. By doing both, you can truly maximize your investment returns.

What Fees Make up Your Expense Ratio?

Low expense ratios
Even small changes add up over time.

The expense ratio of a mutual fund is represented primarily by its 12(b)-1 fees. This includes expenses that the fund incurs for marketing and distribution costs, paying its investment advisor, transfer agent and custodian, and for administrator fees.

The amount of these fees can vary anywhere between .25% and 1.00% of a fund’s net asset value. You can determine the amount of the 12(b)-1 fees from mutual fund’s prospectus, as these are not expressed as flat numbers the way load fees and transaction fees are.

It’s worth noting that 12(b)-1 fees are primarily a mutual fund thing (though there are mutual funds that do not charge them). As a general rule – and as an alternative – exchange traded funds (ETF’s) – do not charge 12(b)-1 fees.

The Long-Term Consequences of Even a Small Increase in Expense Ratios

Though at .25% to 1.00% 12(b)-1 fees can seem almost inconsequential, they can add up over time to have a substantial negative impact on your investment performance. As an example, let’s do a comparison between a mutual fund with 12(b)-1 fees of 1.00% per year, versus an ETF with no 12(b)-1 fees. We’ll assume an investment of $10,000 in each fund, invested through a tax sheltered retirement plan to eliminate tax considerations.

Let’s say that each fund as an average annual overall return of 10%, but the mutual fund return is of course reduced to 9% because of the 12(b)-1 fees. What does that look like after ten years in each case?

The ETF has grown to $25,937. But the mutual fund, with its 1% annual expense cost, reaches only $23,674. That’s a difference of $2,263, or nearly 9%.

But let’s take the example a step further – let’s see what happens over a 30 year time frame.

The ETF grows to a value of $174,494, while the mutual fund reaches only $132,677. By going with the no-fee ETF, you are ahead after 30 years by $41,817, or by nearly 24%! And all because you improved your performance by just 1% as a result of investing your money in a fund with no 12(b)-1 fee.

The 12(b)-1 fee may not matter very much if you’re planning on holding your position in a fund for a short period of time – especially if it’s less than a year. The negative effect of the fee is more fully felt when funds are held for the long-term. This is because, unlike other types of investment fees, the 12(b)-1 is assessed each and every year that you are in the fund. That effectively makes it a permanent reduction in in your investment return.

Do you know how much you are paying in investment fees? One of the best free tools to track your investments is Personal Capital. With Personal Capital, you can view you investments in one location and get a good idea of how your investments are allocated, track performance, and get a better idea of the types of fees you are paying. You can learn more in our Personal Capital review, or by opening a free account.

Other Investment Fees to Watch Out For

This is a good time to back up a little bit and review other fees that can have an effect on your investment return. As stated above, 12(b)-1 fees are especially problematic for long-term holdings. Other fees can have an effect by taking a chunk out of your investment dollars right up front, and also reducing your investment performance. Here are some more investing fees to be aware of:

Transaction fees. These are especially troublesome if you are an active trader. For example, if you make 30 trades per year in a $10,000 account at $8 per trade, that will mean you’re paying $240 per year – or 2.4% of the value of your account – just in transaction fees. You can lower this by switching to a broker who either has lower transaction fees, or offers a certain number of free trades.

Load fees. Load fees on mutual funds are an even bigger problem. These can be anywhere from 1% to 6% of the value of your investment, and can be charged either on the front, the back or even both. The ideal situation of course is to invest in a no-load fund that has no 12(b)-1 fees either. That mostly means ETF’s.

Account maintenance fees. Generally, these fees have far less impact than transaction fees or loads, but since they are also assessed annually they will have a negative effect on investment return. A $10,000 account with a $150 annual account maintenance fee, will be giving up 1.5% in returns automatically.

The trick is to mix the lowest cost funds with the lowest cost account brokerage. If you can do that successfully, you’ll be ahead of the investment game by default.

How much attention do you pay to 12(b)-1 fees?

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About Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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