Friday, 1 June 2007

Why Management Expense Ratio is So Important

One tenth of one percent (0.1%) seems like a trivial number not worth bothering about when it comes to the expenses charged by fund companies to manage our money in mutual funds or Exchange Traded Funds (ETFs), doesn't it? The expense ratio (ER or MER) is the amount levied by the management company as a percentage of net assets in the fund. It is not in any way dependent on the investing success or performance of the managers (see the Wikipedia post on mutual funds for details).

Another way to look at the ER is that it is a reduction in the net return available to fundholders. Managers must make up their percentage fee and better in order to make money for you and me. For example, if the fund is $100, the ER is 1% or $1 per year, in order to gain 6% net, the fund must go up by 7%/$7. Alternatively, the same net gain can be achieved with a lower investment gain and a lower fee. Or, to put it yet another way, with same investment gain, as I am illustrating in this post, and a lower fee, the net gain is higher. In the case especially of passive index funds whose aim is to replicate the gains (and the losses when they occur) of an index such as the S&P 500 or the TSX, there shouldn't be a lot to pick from between various ETFs or funds. Therefore, the lower the expense ratio, the more of the index gain is left for the investor. Since the MER is a known, predictable expense, the opportunity to lower it is pretty well a guaranteed, risk-free return. In short, the lower MER, the better, other things being equal (and they aren't always but interestingly those funds with lower MERs tend to be better in those other things too).

So how much does it matter? I've created a simple table in the accompanying graphic to show the numbers and the results are dramatic. The table shows percentages which are to be understood as the difference in rates of return - i.e. the effect of extra or less MER. Thus the table shows what an ETF/fund that charged 0.1%, 0.2%, 0.5%, 1.0% or 2.0% more would have produced. For example, the Vanguard FTSE All World ex US (VEU) has an MER of 0.25% while the iSharesMSCI EAFE (EFA) has an MER of 0.35%. They are not exactly the same index but the effect of difference of 0.1% in MER will amount to $201.91 after 20 years for every $10,000 invested, as shown in light blue cells of the graph. Multiply by the size of your portfolio to see the total amount.

$201.91 is a relatively small difference but the other columns show how significant the compounding effect can be for long periods and bigger MERs. The 2.0% column is of special interest to Canadians who pay the highest fund expense fees, which are high by something approaching 2% in my view. The moral of the story is to pay close attention to MER - the lower the better.

1 comment:

Anonymous said...

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