Are Mutual Funds/ETF Fees (Expense Ratios) Important?

Ever wonder how Wall Street makes money off your 401k? Why are they so interest in the few dollars that you put away each month. Well, it adds up trillions of dollars invested and they consistently take their piece of that each year whether markets are up or down.

First there are fees associated with the 401k plan itself, the company that administers the plan. You can find out those fees by asking your HR department to get a disclosure of those fees, but even on a more basic level the mutual funds themselves that are options in your 401k plan cost money. These are the same kinds of fees that mutual funds or ETFs charge you in your IRA.

Next time you log into your 401k plan or IRA website, and click through the selection of mutual funds look for something called an expense ratio. This is the percentage of invested money that the mutual fund grabs each year to pay for the administration of the fund, including the salaries of the portfolio managers as well as the marketing, bookkeeping, and other costs of the fund along with a healthy profit margin. These fees can be anywhere of 0.04% all the way up to 1.5% or even higher.

Obviously, you want to stick to the lower end of the spectrum. If you find a fund with a ratio of less than 0.2% you are probably dealing with an index fund. An index fund is one that tracks a basket of pre-determined stocks (like the S&P 500 which are simply the 500 largest publicly traded companies). These do not take a lot of work to manage and are therefore cheaper for the mutual fund company to run – passing the savings off to you. We at NWW recommend making these the foundation of your portfolio as they provide some built-in diversification and offer a major cost efficiency.

There are of course mutual funds that are actively managed, with portfolio managers who try to pick the right stocks and the right time to beat the market (index funds are designed to match the market they are tracking). These actively managed mutual funds are where you want to be very careful with fees as they can get sky high. Generally, you should avoid mutual funds or ETFs that charge an expense ratio above 1%. The reason being is that not only do these funds have to outperform the market (a feat that is very difficult to do), but they must outperform it by 15-20% consistently (even harder to accomplish) to break-even once you factor in the higher fee charged. The higher fee is also a higher barrier to beating the market.

One percent might not seem like much, but if the market gives you a 7% return on average, 1% represents 1/7th or 15% of your total return. Let’s remember how important those returns are to your compounding returns – making either 7% or 6% (if one percent is given away to the fund manager), can result in massive differences over two or three decades. This can mean tens of thousands (or even hundreds of thousands depending on balances and duration) in lost earnings on your investments due to high expense ratios. Here is a handy calculator that you can play with that shows the impact of expense ratios – it’s scary!

This is why investing in index funds that do not try to be heroes and just match the market, are such a great option. They let you keep nearly all market gains by charging miniscule fees often between 0.04 – 0.2%.