How to understand expenses matter relative to investment type for mutual funds?

Question

From Wikipedia

Expenses matter relative to investment type

There are three broad investment categories for mutual funds (equity, bond, and money market - in declining order of historical returns). That is an over simplification but adequate to explain the effect of expenses.

• In an equity fund where the historical gross return might be 10%, a 1% expense ratio will consume approximately 10% of the investor's return.
• In a bond fund where the historical gross return might be 8%, a 1% expense ratio will consume approximately 12.5% of the investor's return.
• In a money market fund where the historical gross return might be 5%, a 1% expense ratio will consume approximately 20% of the investor's historical total return.

Thus, an investor must consider a fund's expense ratio as it relates to the type of investments a fund will hold.

I wonder how to understand the relation between the investment category of a mutual fund and its expenses from the above quote?

The three examples actually do not explain the relation to me, because One can shuffle the investment categories with the return rate and expense ratio. The ratio of the expense to the return does not depend on the investment categories, but only on the return rate and the expense ratio. Am I right?

Thanks!

Answer 1

The net return reported to you (as a percentage) by a mutual fund is the gross return minus the expense ratio. So, if the gross return is X% and the expense ratio is Y%, your account will show a return of (X-Y)%. Be aware that X could be negative too. So, with Y = 1,

• If X = 10 (as you might get from a stock fund if you believe historical averages will continue), then the net return is 9% and you have lost (Y/X) times 100% = 10% of the gross return.

• If X = 8 (as you might get from a bond fund if you believe historical averages will continue), then the net return is 7% and you have lost (Y/X) times 100% = 12.5% of the gross return.

and so on and so forth. The numbers used are merely examples of the returns that have been obtained historically, though it is worth emphasizing that 10% is an average return, averaged over many decades, from investments in stocks, and to believe that one will get a 10% return year after year is to mislead oneself very badly. I think the point of the illustrations is that expense ratios are important, and should matter a lot to you, but that their impact is proportionately somewhat less if the gross return is high, but very significant if the gross return is low, as in money-market funds. In fact, some money market funds which found that X < Y have even foregone charging the expense ratio fee so as to maintain a fixed $1 per share price. Personally, I would need a lot of persuading to invest in even a stock fund with 1% expense ratio.