Comparing expense ratios
The cost of operating a fund varies across investment categories, investment strategies, and fund sizes. Funds with higher internal costs generally pass these costs on to shareholders through expense ratios. If a fund’s assets are small, for example, its expense ratio might be relatively high, because the fund has a limited asset base from which to meet its expenses. Generally, expense ratios are inversely proportional to funds’ assets. As a fund’s asset size increases, its fixed cost per unit asset decreases, allowing lower expense ratios.
For example, international funds are typically very expensive to operate because they invest in many countries and may have staff all over the world, equating to higher research expenses and payroll. Large-cap funds, on the other hand, tend to be less expensive to operate. While it’s reasonable to compare expense ratios across multiple international funds, it wouldn’t make sense to compare the costs of an international fund against a large cap fund.
Investors shouldn’t compare foreign equity ETFs like the iShares MSCI EAFE ETF (EFA), with an expense ratio of 0.34%, to large-cap U.S. equity ETFS like the SPDR S&P 500 ETF (SPY), which has an expense ratio as low as 0.09%, as it invests in the highly liquid investment-grade U.S. equity of companies like Apple Inc. (AAPL) and Google Inc. (GOOG)—representing 7.4% of the portfolio.
However, as you can see from the chart above, U.S. bond market ETFs like the Core Total U.S. Bond Market ETF (AGG) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) are comparable, as both fall under the total bond market ETF category.
It’s important to compare funds from similar investment categories. Moreover, a difference of a few basis points may seem minuscule within the confines of a year, but when you look at expenses over time, it’s clear that ETFs have the potential to save you a lot of money.
For example, say fund A and fund B are similar in every aspect—except their expense ratios. Fund A has an expense ratio of, say, 0.5%, while fund B charges 2.5%. Assume both funds give an average annualized gain of 10%. Now, let’s make an initial investment of $10,000 in each of these funds. In 20 years, the value of fund A, after adding the annual gain and deducting the expense ratio for each year, would be $61,159. Fund B, on the other hand, would be able to aggregate a value of just $46,022 in 20 years. Consequently, fund A, with a 0.5% expense ratio, is able to aggregate about 33% more value than fund B, with a 2.5% expense ratio. While funds A and B have performed equally well in the market, as both give an average annualized gain of 10%, the 2% difference in expense ratio leads to a 30% difference in investment value in 20 years.