Do Expense Ratios in Mutual Funds Really Matter?

Park Place Expensive Real Estate Monopoly

Let’s hope your fund’s costs don’t land you here.

“Joy has no cost.”
–Marianne Williamson

I recently had a reader ask me the following question:

Hypothetically if you were going to invest $100,000 would you do it with:

Company A whose mutual fund has an [expense ratio] of .5% and a historical net return of 8% or
Company B whose mutual fund has an [expense ratio] of 2% and a historical net return of 11%?

Would you always choose whichever one gives you the higher net return? Since bottom line that is the $ in your pocket?

The gut reaction that most people have to this question is to go with the net return of 11%. Higher is better, right?

In order to answer this question, we need to find out a little more information, namely:

  • What type of fund is this? What does this fund invest in? Domestic stocks? International stocks? Pork snout futures?
  • Is it actively or passively managed? One would assume that an index fund would have a lower expense ratio, although I’ve seen some front loaded mutual funds that invest in the same indices that have exorbitant 12b-1 fees and front loads, completely destroying the value of investing in an index fund in the first place.

The reason I ask the first question is because what you are investing in depends on what sort of asset allocation you’re trying to achieve. In general (with some exceptions), the younger you are, the more you want to invest in equities, a.k.a. stocks, and the older you are, the more you want to invest in fixed income, like bonds, annuities, CDs, etc.

Therefore, if Company A is a bond fund and Company B is a stock fund, then you would expect to see a difference in performance. In general, bond funds will have a lower rate of return than stock funds, but the bond funds will also have peaks and valleys that aren’t as dramatic as a stock fund will. Think of the difference between gently rolling hills and a rollercoaster.

If Company A is a bond fund and Company B is a stock fund, then you’re comparing two different types of funds, and it’s not really appropriate to horse race them against each other. You need to be comparing the same types of mutual funds with each other.

However, if Company A and Company B’s funds both invest in the same asset class, then you need to look at the second question.

In this case, I’d bet the farm (if I had one) that Company A is an index fund and Company B is an actively managed fund.

Between actively managed funds and index funds, I’m choosing index funds every time.

Why?


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Because, as we saw in “Do You Have to Be Lucky to Beat the Market?”, you can’t tell if a manager is skillful enough to outperform the market for somewhere between 25 and 60 years. Even if, after that time period, you can statistically determine that the manager is skillful rather than just lucky, you’re still subjecting yourself to two major risks investing with that manager:

  • Retirement risk. If your manager has been going at it for 25-60 years, he’s eventually going to want to call it a day and ride off into the sunset. Good luck determining if the next manager is equally as skilled.
  • Beer truck risk. Even if the manager does want to continue until he drops dead at his desk while managing money, what if, after the 4 PM closing bell today, he steps outside and gets run over by the beer truck? No more manager.

Even if you were able to pick two funds that invested in the same asset class that were actively managed and you could determine that both managers were skillful and not lucky, there’s even one more metric that may render the absolute returns moot:

Alpha.

What’s alpha, besides the first name of the star that’s closest to us not named The Sun?

Alpha is a measurement of how much an investor earns beyond what would normally be expected given the riskiness of the investments he chooses.

In order to figure out alpha, you need to know beta.

Beta is how much more or less volatile the investments are compared to the general market.

The general market has an beta of 1. If a fund manager chooses investments that are slightly more volatile than the market as a whole, he might have a beta of 1.2. That would mean that his investments should go up 20% more than the market in general and go down 20% more than the markets in general.

Because of the additional volatility, and, hence, risk, the manager should outperform the market by 20%.

How much more or less he earns compared to his beta-tied expectations is alpha.

Expenses affect that alpha, since the returns are returns net of expenses.

Here’s the formula:

α = Portfolio return – [Risk free interest rate + (Market Return – Risk free interest rate) X Covariance (Invested assets, benchmark return) / Variance (benchmark return)]

That last part starting with covariance is the long form for β.

Head spinning yet?

If I make the simplifying assumption that Company A’s fund is an index fund invested in the broad stock market and Company B’s fund is an actively managed fund invested in the broad stock market, I’m choosing Company A every time. Even if Company B’s manager has statistically proven that he has skill as opposed to luck, I’m not going to take the risk that he will continue to manage that fund until I peel the garlic.

I prefer to keep my investments a simple as possible, value cost averaging and rebalancing annually, and focusing on the things I can control. Remember, in almost every case, actively managed funds underperform their index fund counterparts.

If I want to test my luck, I’ll go to Vegas. I prefer not to go to Vegas and gamble on the status of my financial independence.

What about you? Which one would you pick? Do you think you can beat the market? Let’s talk about it in the comments below!

About Jason Hull, CFP®

Jason Hull, CFP®, is the Chief Technology officer of myFinancialAnswers, an online comprehensive financial planning service.

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