When it comes to investing, it pays to keep your mutual fund costs low. We’ve built our firm around a big idea: you shouldn’t have to pay high fees in order to get good financial advice.
And when it comes to the investments we recommend to clients, one of the most important numbers we look at is the expense ratio. The expense ratio, or ER, is a measure of the operating cost of the mutual fund or ETF. According to the latest Morningstar Fund Fee Study, the industry average expense ratio is 0.45%.
The good news is that cost is roughly half of what it was just 20 years ago. The bad news is that it is arguably about three times as high as needs to be.
In the history of personal investing, few innovations have benefitted individual investors more than the index fund. The index fund has revolutionized low-cost investing for individuals. No one deserves more credit for this revolution than Vanguard founder John Bogle: the “patron saint of the amateur investor“.
In 2003, Bogle contributed an article to CFA magazine which introduced what he called the “costs matter hypothesis” or CMH. With this tongue-in-cheek alternative to the efficient markets hypothesis (EMH), Bogle observed:
“We don’t need the EMH to explain the dire odds that investors face in their quest to beat the stock market. We need only the CMH. Whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur.”
But HOW MUCH do mutual fund costs matter?
The expense ratio measures MANY of the costs associated with managing a mutual fund or ETF, but it doesn’t measure ALL of them. The most significant costs that the expense ratio does not include are transaction costs. This is the amount of money spent to buy and sell the securities owned by the fund. For an actively managed fund, transaction costs can be over one percent per year. Even for an index fund they can top 0.2%. Index managers have ways to offset these costs, in part or in whole, but not all index fund managers are equally adept at doing this. And even something as innocuous as the date the index is rebalanced can impact annual returns by 0.3% or 0.4%, according to research by Corey Hoffstein.
I have conducted my own analysis of ETF expense ratios by comparing the reported ratio to the difference in performance between the fund and a risk-adjusted benchmark. What I found was not surprising.
Funds with expense ratios over 0.30% were highly likely to underperform the risk-adjusted benchmark.
Funds with expense ratios under 0.20% were much less likely to do so.
And because “costs matter” we avoid funds with expense ratios over 0.25% except in the most unusual of circumstances and we work to ensure that the average expense ratio of portfolios is under 0.15%.
Why not push lower? We often do, with many of our most commonly used funds having expense ratios under 0.08%. However, we want our clients to focus on their overall portfolio picture. Obsessing over any single metric is counterproductive. Portfolios are more resilient when they are well diversified, after all.
Sometimes the best fund for a particular goal justifies a slightly higher mutual fund costs. Even when compounded over thirty or more years, difference of 0.10% get lost in the noise of random market fluctuations.