Why expense ratios affect ETF investors’ returns

Expense ratios

To see how expense ratios can affect investments over time, let’s compare the returns of several fixed income ETFs that differ only in expense ratio. We’ve considered select ETFs with different expense ratios. We assume that the expense ratio is compounded and deduct it from total returns to get net returns. The following table depicts the returns on a $10,000 initial investment.

From the table above, it’s clear that expenses ate away a significant portion of the return. The higher the expense ratio, the deeper the decline in investment value. Also, the higher the investment period, the greater the impact of expense ratios due to the compounding effect. The Core Total U.S. Bond Market ETF (AGG) tracks the index that measures the performance of the U.S. investment-grade bond market, all with maturities of more than one year. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) tracks an index measuring the performance of 600 highly liquid investment-grade corporate bonds.

Both AGG & LQD have very low expense ratios. We note that net or effective returns (that is, the return after expenses) fall to 3.39% versus perceived returns of 3.64% for AGG for the past three years. For LQD, a 6.58% returns for the past three years became 6.1%. For the past five years, the returns decline to 4.09% from 4.51% for AGG, while for LQD, they became 7.73% from 8.54%. For ten years, the returns reduced even further. In AGG, they went down from 4.29% to 3.46%. In LQD, the effective return after ten years was 3.69% from 5.26%.