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While doing a bit of research on choosing mutual funds, I found that almost all the blog posts and web pages seem to suggest how harmful the expense ratio is, how much money we lose over time due to the expense ratio, etc. That naturally makes an investor feel to choose funds with a lower expense ratio. However, it is also my understanding that the NAVs reported by mutual funds already makes necessary adjustment for the expense ratio, so that the 1/3/5 year returns typically reported by the fund research tools are the ones realized after the deduction of the expense ratio. In other words, we do not need to account for the expense ratio ourselves while shopping for funds. Lowering the expense ratio, according to my understanding, only matters when we have another fund with a similar distribution of holdings, and has a lower expense ratio which yields a higher return. My question is, should we really be looking at the expense ratio while choosing funds as far as the rate of return is concerned?

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  • Of course you should… and whether it matters depends on the size of that ratio. – Robbie Goodwin Jun 7 at 23:56
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Past performance accounts for the expense ratio, but is (proverbially) not indicative of future results. In particular, going by past performance and choosing a fund that has recently beaten the market will, according to the efficient market hypothesis (EMH), give no greater chance of beating the market in the future. In fact, it may incur excessive risk.

The expense ratio is one thing that really is predictable -- it is a direct drag on your return and this predictability does not conflict with EMH. So, looking at the expense ratio separately is a way of distinguishing signal (a recurring effect on returns going forward) from noise (past performance fluctuations).

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    Past performance is not a guarantee of future results. It most definitely is indicative. – Ben Voigt Jun 4 at 16:29
  • Correct me if I'm wrong, but if you follow the EMH, you'd generally avoid mutual funds in favour of index funds or ETFs, so that would be the argument (as it always is) instead of looking at expense ratio. If you've decided to invest in a mutual fund, you're implying you don't follow the EMH. Noise / luck would probably be the main argument to considering expense ratio separately. Although also maybe not, as a higher average return is less likely to be attributable to luck or noise (but it's not clear at which point a decreased likelihood of luck would cancel out an increased expense ratio) – NotThatGuy Jun 4 at 22:50
  • @NotThatGuy ETFs and mutual funds are often interchangeable... just look at VTI and VTSAX. – ahaas Jun 10 at 23:19
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Yes.

While the expense ratio is deducted from the NAV, it is still relevant. Imagine you have two index funds tracking the same index. One with 0.1% and the other with 1% TER. Obviously the cheaper fund will outperform the expensive one.

Now we add a layer of complexity and pick active funds. The expected return of a randomly chosen fund before costs is the market average. As high performing funds do not tend to keep their outperformance in the future, this is equal to choosing a well performing fund. Therefore expenses are the most significant predictor of your long term return after costs.

PS: you might no have the impression that funds perform average on average. Check for survivorship bias

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  • "The expected return of a randomly chosen fund before costs is the market average" Not sure I agree with this as stated. Funds can have different expected return based on their level of risk, as well as by asset class, sector, etc. A "random" bond fund should have a lower expected return than a small-cap equity fund, for example. – D Stanley Jun 3 at 17:54
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    Sure. But comparing returns between bond funds and equity funds is as pointless as comparison with an inappropriate benchmark. A value fund needs to be compared to a value index, small caps to small cap index, a bond fund to a bond index, etc. Which - as a note to the OP - is one way funds can claim benchmark beating performance. Set your benchmark let's say to the MSCI World Value but buy growth stocks... – Manziel Jun 3 at 19:02
  • @Manziel I would be pretty impressed to see an ETF that pulls such an obvious bait-and-switch. – Kevin Arlin Jun 3 at 20:13
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    Not an ETF but the fund of German crash prophet Dirk Müller was doing exactly this. They named the MSCI W value as their benchmark but bought big tech growth stocks. The reason being that value investing tends to produce lower returns in extended bull markets, so you get a systematic outperformance for that time. After underperforming even a rigged benchmark they removed their benchmark. (The main reason for the bad performance of this particular fund is that it is targeted on a major crash being right around the corner. But the futures to protect against a crash cost almost all returns) – Manziel Jun 3 at 20:48
  • @Manzieln That seems to be an outlier. I've been investing in mutual funds for more than 35 years and I don't think I've ever seen one compare their returns to an irrelevant index. Sometimes they'll mention two benchmarks, one directly relevant and also a more general benchmark like S&P 500. – Barmar Jun 4 at 14:43
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Lowering the expense ratio, according to my understanding, only matters when we have another fund with a similar distribution of holdings, and has a lower expense ratio which yields a higher return.

That's a big "only", since investment companies usually offer similar funds.

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  • Between Fund A that offers 15% return in 5 years with 0.75% TER and Fund B that offers 14.5% return in the same period with 0.02% TER, which one do you choose? Assume, both of them have the same holding distributions – Holmes.Sherlock Jun 3 at 20:21
  • @Holmes.Sherlock probably whichever one is most convenient for me (like where I already have most of my money). – RonJohn Jun 3 at 20:38

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