Duration and loss
From the table below, it’s clear that expenses ate away a significant portion of returns. The higher the expense ratio, the deeper the decline in an investment’s value. Also, the higher the period of investment, the greater the impact of expense ratios due to the compounding effect. For ETFs with a higher expense ratio, such as EMB, investors lost 3.27% on their five-year return, although the fund originally shows a return of 11%. Put more generally, an investor lost nearly one-third of the return due to the effect of expenses. For TBF, investors lost 2.5% on their three-year return. Even for ETFs with very low expense ratios, investors had lost around 1% to 1.5% on their total investment for five-year terms. In absolute dollar terms, the effect would cost an investor dearly the larger the investment, as shown in the following tables.
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Now let’s imagine that an investor would receive a return of 5% each year for the next three years on their investment. Let’s imagine an expense ratio of 0.40%. We’ll try to determine in our next table how much of the investment would be diluted due to expenses. We’ll also try to find out how the investment value would look for a higher and lower expense ratio. Let’s consider an initial investment of $100,000.
From the table above, we can estimate how much an investor in our ETF would lose in investment value. After one year, a 5% return on the investment in the ETF would reduce to 4.58% if the expense ratio were 0.40%. For a longer period of three years, the returns would decrease to 14.38% from 15.76% due to the expense ratio. For five years, the fall in returns is even higher. After five years, an original 27.6% in returns would come down to 25.1%. The table above also shows how the investor would lose money if the expense ratio varied.
To learn more about investing in fixed income ETFs, see the Market Realist series Hedging your portfolio: Simple strategies and outstanding benefits.