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I've never been an investor before, but I recently came into some money.

In my understanding, expense ratios for mutual funds and ETFs are typically incorporated into the yield or ticker price.

If that's the case, should I care about expense ratios? If so, how should I take them into consideration when comparing funds? I'm in the U.S. if that matters.

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You absolutely should consider expenses.

Why do they matter when the "sticker price" already includes them? Because you can be much more certain about what the expense ratio will be in the future than you can about what the fund performance will be in the future.

The "sticker price" mixes generalized economic growth (i.e., gains you could have gotten from other funds) with gains specific to the fund, but the expense ratio is completely fund-specific. In other words, when looking at the "sticker price" performance of a fund, it's difficult to determine how that performance will extend into the future. But the expense ratio will definitely carry into the future. It is rare for funds to drastically change their expense ratios, but common for funds to change their performance.

Suppose you find a fund that has returned a net of 8% over some time period and has a 1% expense ratio, and another fund that has returned a net of 10% but has a 2% expense ratio. So the first fund returned 9%-1% = 8% and the second returned 12%-2%=10%. There are decent odds that, over some future time period, the first fund will return 10%-1%=9% while the second fund will return 10%-2%=8%. In order for the second fund to be better than the first, it has to reliably outperform it by 1%; this is harder than it may sound. Simply put, there is a lot of "noise" in the fund performance, but the expense ratio is "all signal".

Of course, if you find a fund that will reliably return 20% after expenses of 3%, it would probably make sense to choose that over one that returns 10% after expenses of 1%. But "will reliably return" is not the same as "has returned over the past N years", and the difference between the two phrases becomes greater and greater the smaller N is. When you find a fund that seems to have performed staggeringly well over some time period, you should be cautious; there is a good chance that the future holds some regression to the mean, and the fund will not continue to be so stellar.

You may want to take a look at this question which asked about Morningstar fund ratings, which are essentially a measure of past performance. My answer references a study done by Morningstar comparing its own star ratings vs. fund expenses as a predictor of overall results. I'll repeat here the take-home message:

How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time, with a few exceptions. How often did the star rating beat expenses as a predictor? Slightly less than half the time, taking into account funds that expired during the time period.

In other words, Morningstar's own study showed that its own star ratings (that is, past fund performance) are not as good at predicting success as simply looking at the expense ratios of the funds.

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YES.. Management fees cut directly into your profits. A fund which achieves 8% growth but costs 1% to maintain delivers only 7% to you. Compounded over years, even a relatively small difference can add up to a significant amount of money.

This is one of the advantages index funds have. They may not be as "sophisticated" as human-managed funds, but their expense ratio is so much lower that the end result for the investor is often as good as or better than the more expensive products.

In fact, at least one study found that, for each category they researched, low expense ratio was a better predictor of good return on investment than anything else they looked at.

That doesn't mean cheapest is always best or most expensive is always worst .... but it does mean you should be very, very sure an expensive fund really is that much better before choosing it. And sticking with simple index funds may be a perfectly reasonable choice.

  • So is my understanding not correct? That is, if I'm looking at a chart of historical returns for a fund with the 8% growth and 1% expense ratio, wouldn't it just say 7%? – shadowtalker Sep 17 '15 at 2:46
  • Check with whoever drew up the chart. – keshlam Sep 17 '15 at 3:03
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Should you care? From Vanguard:

The long-term impact of investment costs on portfolio balances Assuming a starting balance of $100,000 and a yearly return of 6%, which is reinvested

Check out this chart, reflecting the impact of relatively small expense ratios on your 30 year return:

enter image description here

All else being equal you should very much care about expense ratios. You end up with a significantly smaller amount if your pre-expense return is the same. A 0.75% difference in ER compounds to 20% over 30 years.

If so, how should I take them into consideration when comparing funds? I'm in the U.S. if that matters.

If they track the same index, cheaper is better.

The cases where higher expense ratios might be better are if you believe that index will outperform the market by enough to recoup the cost of the ER.

There is significant research that most funds do not do this.

  • But why would I ever consider looking at pre-expense returns, when the "sticker price" typically factors in the expense ratio? – shadowtalker Sep 17 '15 at 2:41
  • A better analogy would be MPG rating -- and that doesn't account for whether the car needs premium fuel or more expensive maintenance. Don't assume that any number accounts for all the costs -- it's your responsibility to ask. – keshlam Sep 17 '15 at 3:06
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    @ssdecontrol BrenBarn's answer explains this - but historically, most funds do not actually return better than their index they are compared against (especially for longer periods of time). – enderland Sep 17 '15 at 13:44

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