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Carla Fried: Hidden mutual fund and ETF fees can cost you plenty

Carla Fried, Rate.com on

Published in Home and Consumer News

With more than $30 trillion riding on U.S. mutual funds and exchange traded funds, you would think investors would have a strong grasp of what they pay to own the diversified portfolios.

Mutual funds and ETFs snip off money each year from the portfolio’s assets to cover their costs. Those annual costs are called the annual expense ratio. (Yes, Fidelity has four index funds that don’t charge an annual expense ratio. They are outliers.)

A recent survey by State Street Global Advisors seems to have some encouraging news. Nearly nine in 10 participants say they are aware of expense ratios. But being aware does not translate into being fee smart. Just one-third of participants said they fully understand what an expense ratio is.

And that confusion can be costly. An expense ratio is a seemingly small fee that ends up having a big impact on the growth of your fund and ETF investments over time.

Take a few minutes to master the math of expense ratios, and you just might find an easy way to boost your future performance, simply by paying less to invest in a mutual fund or ETF.

Expense ratios: The percentage you pay to own a fund

Expense ratios are expressed as a percentage. A fund with a 1% expense ratio takes 1% of the fund’s assets each year to cover its costs. A fund with an 0.50% expense ratio shaves off a half a percentage point each year to cover its costs. A fund with an 0.10% expense ratio charges one-tenth of one percent (or 10 basis points in financial lingo).

The financial service industry is quite happy if you don’t think any of that is worth your time. It loves customers who think 1% is nothing, and can’t be bothered thinking through the ramifications of paying 1% vs. 0.10%.

In reality, it is a huge deal for investors.

Let’s assume you own a fund that has a pre-fee return for the year of 8%. If that fund charges a 1% annual expense ratio, the actual gain your account is credited with will be 7%. If the fund instead charges an 0.10% expense ratio, your account will be credited with a return of 7.9%.

A $10,000 investment today that compounds at an annualized 7% a year will be worth around $76,000 in 30 years. If the $10,000 compounds at an annualized 7.9% it will be worth nearly $98,000. That’s $22,000 that slips right through your fingers.

Or consider if you were to contribute $6,000 a year for 30 years to an IRA. ($6,000 is the current maximum IRA contribution for anyone younger than 50.) At a 7% annualized return you would have around $606,000 or so in 30 years. Earn a net 7.9% and you will have about $720,000.

The half-hearted transparency of expense ratios

Investor confusion is completely logical given the absurd way funds and ETFs are allowed to report their expense ratios.

The expense ratio is not a line item that shows up in your statements. Your statement is your account value after the expense ratio has been deducted. Out of sight, out of mind.

 

That said, it’s super easy to find a fund or ETF expense ratio. If you log in to your account, you likely will see links for “fund facts,” or fees, and on that page the expense ratio will be clearly listed. Or plug a fund’s ticker symbol into a search engine, and the top return will be a data box that includes the expense ratio.

It’s worth the time to make an expense ratio inventory check of all your investments. If you’re investing in funds with expense ratios of more than 0.50% or so you might be missing out on an opportunity to earn more by paying less.

A low-cost target to consider

In the same State Street Global Advisors survey, participants who reported they felt they understood expense ratios said that an annual expense ratio of no more than 0.60% should be considered as “low cost.”

That is a serious overshoot. There are many low-cost index mutual funds and ETFs that charge 0.10% or less. In its most recent survey of fund fees, Morningstar said the average asset-weighted expense ratio for U.S. stock index funds was 0.09%. For a taxable bond fund the average was 0.10%. International stock index funds had an average charge of 0.20%.

As the State Street report points out, anyone who thinks 0.60% is a good deal, is off by a magnitude of 6x.

It’s actively managed mutual funds that are more expensive. The asset-weighted average is 0.66% according to Morningstar. Keep in mind that reams of data over every possible time frame have shown that it is extremely rare for actively managed funds to consistently deliver returns that exceed a comparable index fund.

Making more by paying lower expense ratios

If your investing is confined to a workplace retirement plan, see if there are low-cost index funds offered. You can move money inside a workplace retirement plan (or an IRA) from one fund to another without any tax bill.

If there are no index funds in your workplace plan with expense ratios below 0.30% or so, that’s a signal you’ve got a subpar plan. That said, you always want to contribute at least enough to get the maximum company matching contribution. But beyond that amount, you might want to consider doing additional retirement investing in an IRA where you are free to choose the lowest-cost index funds or ETFs.

If you own expensive funds in regular taxable accounts, you will want to be careful with how you proceed. Exchanging shares of one fund for another will trigger a capital gains tax if the fund shares you are selling are higher than what you paid, or higher than the reinvested value of any dividends and capital gains the fund made in any given year.

Log in to your account, and with a few clicks on the website you can likely get an estimate of your potential tax for selling. You don’t have to sell all the shares at once. The goal is to think through the value of paying tax now to reap the long-term benefit of reinvesting the money in super low-cost funds or ETFs that will leave more money in your pocket.

If you don’t want to deal with a tax bill right now, you can start taking advantage of low-cost index funds and ETFs by directing all fresh investment dollars into the cheapest portfolios.

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