Understanding the Expense Ratio

Comment

Investing 101

In Robert Altman’s loopy live-action film Popeye, starring Robin Williams and Shelley Duvall, there’s a memorable character who greets Williams as he rows into the town of Sweethaven. The following exchange occurs:

The Tax Man: You just docked?
Popeye: I has.
The Tax Man: Ah ha, let’s see here, that’ll be 25¢ docking tax.
Popeye: What for?
The Tax Man: Where’s your sea craft?
Popeye: It ain’t no sea craft, it’s me dinghy and it’s under the wharf.
The Tax Man: Ah ha. ahh-ha. This your goods?
Popeye: They is.
The Tax Man: Yeah. You’re new in town right?
Popeye: If you call this a town, yes.
The Tax Man: Well, first of all, there’s 17¢ new-in-town tax, and there’s 45¢ rowboat-under-the-wharf tax, and one-dollar leaving-your-junk-lying-around-the-wharf tax, so all together, you owe the Commodore $1.87.
Popeye: Uh, who’s this Commodore?
The Tax Man: Is that the nature of question? There’s a nickel question tax.

Any mutual fund investor might feel like Popeye — if mutual funds were even half as forthcoming as the wandering tax collector of Sweethaven. To keep things simple, and to avoid too much explaining, they roll their fees into a single, harmless-sounding line called the expense ratio. Soon, active management feels more like active taxation.

The trouble with expense ratios is that (like taxes) you pay them regardless of how well your manager performs in a given year. Whether the market is up or down, the manager will be taking a slice of your portfolio for his or herself. Mutual funds charge an average expense ratio of 1.43%, according to the Investment Company Institute. Yet fund investors paid on average 0.79%. The nearly 58% difference is partly due to increased demand for low-cost, passive alternatives, such as index funds.

Even 1% is a lot of money. Let’s say you buy a mutual fund designed to own a broad selection of stocks. You agree to pay expenses and fees equal to 1%. You figure it’s a good deal, getting pro money management attention for such a tiny slice of the action.

You could have bought instead one of Vanguard Group’s rock-bottom exchange-traded funds (ETFs) like the S&P 500 ETF (VOO), which has an expense ratio of 0.05%.

The difference? If you bought a fund earning 8% annually, after a year a $10,000 investment would be worth $10,700 in the pricey fund and $10,795 in the cheap ETF. You’d be $95 ahead.

And remember this important fact: 84% of all domestic equity funds underperform their benchmarks.  This is according to S&P’s SPIVA Scoreboard, which compares mutual fund performance to each fund’s appropriate style index.

So, which option sounds better to you: Option A, paying $5 for Vanguard’s S&P 500 ETF, which  virtually guarantees that you’ll match the returns of the S&P 500. Or Option B, paying $100 for a fund with a better than 80% chance of underperforming the S&P 500. Hmmm?

Fast forward three decades. Same funds, same expenses. And, just for laughs, same returns.  In the 1%-expense fund, your total is now $76,123, while the cheaper fund is worth $99,238. The expense difference alone cost you more than $23,000 in total return.

Breaking It Down

What does your fund manager do with $23,000 of your money? Well, running a business is not free. He or she has to eat, and pay the rent, and otherwise operate profitably in the service of building your wealth.

Here’s how the different fees and expenses break down, starting with the expense ratio, the fees associated with the cost of actually running a fund. This money is subtracted from the “pot” and subtracted from the fund annually as a percentage:

Investment advisory fee or management fee: This part of the fee is what you think of when you consider fees at all. This is the cost of buying advice from your well-paid manager “friend.” It’s the biggest line item in the expense ratio and can range from 0.5% to 2% per year.

Administrative fee: Does your fund manager pick up the phone when you call? Lick envelopes and print up and mail the quarterly reports you get in the mail? Of course not. He has a staff for that. And while you might think that’s his business cost to bear, it’s in your expense ratio.

Transfer agent fees: The costs of managing your records when you buy or sell shares in the fund. Again, your fund advisor has better things to do than keep track of this, and keeping track costs money.

Custodian fees: A pass-through to the banks that hold and trade shares on behalf of the fund. The administrative, transfer agent and custodian fee, among the other miscellaneous fees (like legal fees), typically range between 0.2% and 0.4% per year.

12b-1 distribution fee: Sounds official, doesn’t it? Like you’re covering some bureaucratic demand from D.C. that’s not the fund’s fault. Far from it. This one simply means  you’re paying commissions to brokers and marketing and advertising costs to inform potential new  investors about the wonderful fund to which you already belong. In theory, as a fund grows in size it can more widely distribute costs and lower expenses. In practice, it means the managers keep more money.  Plan on a range from 0.25% to 1%.

The Rowboat-Under-the-Wharf Tax

Beyond the fixed running costs, there are special charges, too, made on activities related to buying or selling the fund itself. Chief among these are:

Sales load: You might have bought your fund directly from the fund company. Probably, though, you bought it through a broker. He needs to get paid. That means you. The “deferred” flavor of sales load is charged when you finally sell your shares back to the fund.

You might be told that it’s a good idea to buy a “no-load” fund. That’s just buying a car from the factory, rather than from a dealer. The fund issues shares directly and there’s no broker to pay. Nice, but it doesn’t cut your continuing expenses by a red cent. Yes, no-load funds are better than paying a load, but it’s like financing a fancy new car and getting upgraded floor mats in the deal.

Worse yet, some no-load funds actually do quietly pay an annual fee back to the brokerages that list them, then sock you for part of it in the 12b-1 distribution fee. You get the nifty free floor mats but the finance guy dings you on the way out the door! Ouch.

Account fees: Charges for coming into the fund (purchase fees), staying in the fund (maintenance fees), or leaving the fund (redemption fees). Beginning to feel like Popeye yet?

Maserati down payments: Sports cars don’t buy themselves and investment advisors don’t expect them to. Okay, this one isn’t strictly true, but as the fees pile up it starts to feel like it.

Can you keep more of your money? Mutual funds rarely earn their keep in the long term. By choosing cheaper index funds and ETFs that track the broad market you can eradicate the bulk of the expenses and fees, costs that aren’t adding to your total return.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>