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The Short Answer

Don't Discount Value of Low Fees Over the Long Term

Small differences in expense ratios can mean big bucks down the road.

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Question: I keep hearing how important it is to watch fees associated with my mutual funds. Because fees are incorporated into performance, isn't my bottom-line return what really matters?

Answer: Although you're right that bottom-line return is ultimately what matters most to investors, don't overlook the role fees play in that return. Many investors look at expense ratios charged by funds, see a small number--often less than a percentage point--and assume it hardly matters whether a fund charges a quarter of a point or a full point. But although this small difference might not look like much in percentage terms, over the long haul it can make a dramatic difference in the amount of fees you pay and, ultimately, your bottom-line return, as we'll see in a moment.

How Funds Charge Their Customers
First let's talk about how fees work. Companies that run mutual funds and exchange-traded funds charge investors for their services by imposing a fee on the percentage of assets held in the fund. So, for example, if you hold $5,000 in a fund that charges 1% in fees, the fund company is essentially charging you $50 a year to cover its costs and, in most cases, have enough left over for a profit.  

Although they do incorporate the fund's management and administrative costs, fund expenses don't depict each and every cost investors bear. For example, they don't incorporate sales charges--also known as "loads"--levied on purchasers of some funds. Nor do they include the fund's trading costs, both direct and indirect, as discussed in this article. Those costs are important, but the former type varies by the investor, while the latter kind is difficult to quantify. Fund expenses, by contrast, allow for apples-to-apples comparisons, and the SEC requires expense disclosure. 

All mutual funds and ETFs charge expense ratios of some kind. Domestic-equity fund investors paid on average 0.74%, or 74 basis points, on invested assets in 2011, while investors in taxable-bond funds paid 0.63%, or 63 basis points. Across all categories, including foreign funds, investors paid 0.75%, or 75 basis points, on an asset-weighted basis. The expense ratios paid by investors have generally been declining during the past decade, in part because of the increasing popularity of low-cost index funds. (You can read Morningstar director of mutual fund research Russel Kinnel's recent article on the subject of declining expense ratios here.) Lower average expense ratios, compared with those of actively managed funds, are one of the key advantages touted by indexers, and when looking at the long-term impact expense ratios have on returns, it's easy to see how even a quarter-point difference can have a substantial effect.

Lower Fees, Higher Returns
Let's consider someone making a one-time investment of $10,000. He or she is considering three different funds, one with an expense ratio of 0.25% ( Fidelity Tax-Free Bond (FTABX)), one at 0.50% ( T. Rowe Price Inflation Protected Bond (PRIPX)), and the third at 1.00% (PMC Core Fixed Income (PMFIX)) (for purposes of this exercise, we'll assume all three funds are equal in terms of return potential). Using Morningstar's  Premium Cost Analyzer tool, we project the outcome if the investment is held for 20 years with 7% average annual gains. We then get the following results for each expense ratio level:

25 basis points
total fees paid--$1,029; final value--$36,814; annualized return--6.73%

50 basis points
total fees paid--$1,997; final value--$35,023; annualized return--6.47%

100 basis points
total fees paid--$3,763, final value--$31,697; annualized return--5.94%

As you can see, even small differences in expense ratios can mean a dramatic difference in returns when taken over a long time period and given the effects of compounding. The example we've just seen is for a relatively modest investment. Now let's apply the expense ratios above to a larger number. According to a recent report from Fidelity, the average 401(k) account balance under its administration at the end of last quarter was $74,600. Using that figure, with no principal added and the same 7% annual gain over 20 years, the investment would increase to $274,633 in the fund charging 25 basis points, to $261,272 in the one charging 50 basis points, and to $236,460 in the one charging 100 basis points. As you can see, that seemingly tiny fraction of a percentage point paid year after year can cost tens of thousands of dollars over the long haul.

All this is not to say you should make your fund choices based solely on expense ratio (though, as Kinnel points out in this article, they are a great predictor of fund performance, with low-cost funds consistently beating high-cost funds regardless of asset class and time period). Standard investing principles, such as having a diversified portfolio with time-frame-appropriate allocations to various asset classes still apply. But keeping costs low is a guaranteed way to help maximize returns. In the risk-filled world of investing, it's one of the only sure bets around.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.

Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.