Wednesday, October 20, 2010

Are High Mutual Fund Fees Really So Bad?

Mutual fundImage via WikipediaI was over at Morningstar.Com reading about expense ratios and star ratings. It turns out that lower expense funds do better than higher expense funds. Also expenses are a better predictor of future returns than Morningstar's own star rating. 
Russel Kinnel, Director of Mutual Fund Research, says the star rating is useful but that the expense ratios predict better everytime. "Expense ratios are a strong predictor of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile. 
The math says for every 1% of additional fees, 28% of the total return will be missing. Assume that you are just starting investing and you have 35 years to invest. The balance in your account is $25,000. If returns on in investments in your account over the next 35 years average 7 percent and fees and expenses reduce your average returns by 0.5 percent, your account balance will grow to $227,000 at retirement, even if there are no further contributions to your account. If fees and expenses are 1.5 percent, your account will grow to only $163,000. The difference of 1 percent in expenses gets you 28 percent less. 
This example demonstrates why expense ratios are critical in your investing. A 1 percent difference over time will substantially reduce your investments. We are told, many investment gurus, if you can get consistently high returns the extra expense is not important. But who gets consistent high returns? I have some trouble with Morningstars star rankings. The ranking are a look backwards of fund performance. But we all know how funds can be up one year and down the next. On the check list of rating a fund, it's way down the list. After seeing the math on expense ratios, their is finally a good indicator that is more concrete in nature. When investing your precious dollars every advantage must be taken. It's your responsibility to be aware of all ways to maximize your return. 

1 comment:

  1. The low expense = better performance theory is what John Bogle has built his career on, and it seems that the empirical evidence is proving him right.


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