Question: I keep hearing how important it is to watch fees associated with my funds. Because fees are incorporated into performance, isn't my bottom-line return what really matters?
Answer: Although you're right that bottom-line return is ultimately what matters most to investors, don't overlook the role fees play in that return. Many investors look at expense ratios charged by funds, see a small number--often less than a percentage point--and assume it hardly matters whether a fund charges a quarter of a point or a full point. But although this small difference might not look like much in percentage terms, over the long haul it can make a dramatic difference in the amount of fees you pay and, ultimately, your bottom-line return, as we'll see in a moment.
How Funds Charge Their Customers
First let's talk about how fees work. Companies that run unit trusts and exchange-traded funds (ETFs) charge investors for their services by imposing a fee on the percentage of assets held in the fund. So, for example, if you hold £5,000 in a fund that charges 1% in fees, the fund company is essentially charging you £50 a year to cover its costs and, in most cases, have enough left over for a profit.
Although they do incorporate the fund's management and administrative costs, fund expenses don't depict each and every cost investors bear. For example, they don't necessarily incorporate the fund’s performance fee, nor do they include the fund's trading costs, both direct and indirect. Those costs are important, but the former type varies by fund, while the latter kind is difficult to quantify. Fund expenses, by contrast, allow for apples-to-apples comparisons.
All mutual funds and ETFs charge expense ratios of some kind. Thankfully for investors, overall expense ratios have generally been declining during the past decade, in part because of the increasing popularity of low-cost index funds. Lower average expense ratios, compared with those of actively managed funds, are one of the key advantages touted by indexers, and when looking at the long-term impact expense ratios have on returns, it's easy to see how even a quarter-point difference can have a substantial effect.
Lower Fees, Higher Returns
Let's consider someone making a one-time investment of £10,000. He or she is considering three different funds, one with an expense ratio of 0.25%, one at 0.50%, and the third at 1.00%. (For purposes of this exercise, we'll assume all three funds are equal in terms of return potential). We can project the outcome for each of these funds if the investment is held for 20 years with a 7% average annual gain. We then get the following results for each expense ratio level:
25 basis points
total fees paid--£1,029; final value--£36,814; annualised return--6.73%
50 basis points
total fees paid--£1,997; final value--£35,023; annualised return--6.47%
100 basis points
total fees paid--£3,763, final value--£31,697; annualised return--5.94%
As you can see, even small differences in expense ratios can mean a dramatic difference in returns when taken over a long time period and given the effects of compounding. The example we've just seen is for a relatively modest investment. But the bigger the amount invested, the bigger the impact of fees. Over time, a seemingly tiny fraction of a percentage point paid year after year can cost tens of thousands of pounds over the long haul.
All this is not to say you should make your fund choices based solely on expense ratios. Standard investing principles, such as having a diversified portfolio with time-frame-appropriate allocations to various asset classes still apply. But keeping costs low is a guaranteed way to help maximise returns. In the risk-filled world of investing, it's one of the only sure bets around.
