ETF Expense Ratios: Their Impact on Long-Term Performance

Exchange-traded funds, or ETFs, have become the most popular option for investors since 2008. Not only are retail investors moving to ETFs, but even institutional investors like hedge funds have been buying ETFs at a breakneck pace, leading to nearly $37 billion of large hedge funds’ money being put in ETFs by the third quarter of 2014.
There are many reasons these assets have seen more interest, but the two biggest are easy diversification and low costs. Unlike actively managed mutual funds, most ETFs are passively managed and exist only to track an index. This means they cost less than mutual funds, while providing the same broad exposure and diversification that mutual funds have always provided.
With some ETFs, the expenses are even lower than with others, even if they do virtually the same thing. A good example would be to compare the SPDR S&P 500 ETF (SPY) with funds that track the same index from iShares (IVV) and Vanguard (VOO). SPDR’s fund has an expense ratio of 0.09%, while iShares charges 0.07% and Vangurad is even cheaper—at just 0.05%.
Paying for Complexity
These expense ratios are so cheap because they are very basic products: they provide investors with exposure to all of the S&P 500, with no attempt to mitigate risk or diversify into other asset classes.
Funds that do more also charge more.For instance, Invesco’s PowerShares BuyBack Achievers (PKW) has a lot of crossover with SPY, but its expense ratio is 0.68%, almost 8 times higher. While some may recoil in horror, the reality is that the expense ratio is a result of the complexity of the fund’s strategy: which is to track and invest in companies that buyback shares more aggressively, while many companies in the S&P 500 will do little or no share buybacks at all. In some markets, a fund like PKW will outperform the S&P 500, so that higher expense is more than offset by the higher returns.
 
The Hit from Expenses
While a high expense ratio is sometimes acceptable because the fund’s unique and complicated strategy requires it, investors need to understand how expenses impact their returns in the long term. Expenses will impact the long-term performance of an investment because the cost will compound over time. This is because, the more you pay expenses, the less your money is going to work earning gains in the marketplace.
In one or two years, the difference that higher expenses plays in lowering returns is small. After one year of earning a 10% return, a fund with a 0.5% ratio will yield a $950 profit on a $10,000 investment, while a fund with a 2% ratio will yield an $800 profit. That’s big, but not horrifying.
What is horrifying is what happens over time. If we get that 10% return over 10 years, our 0.5% expense ratio fund will be worth $24,782.28 by year 10. Our 2% expense ratio fund, however, will be worth only $21,589.25—a difference of over $3,000!
You can see just how drastically expenses drag down returns over time with this chart—note how the effect gets worse over time, and worse with higher expenses:

 
How to Lower Expenses
 
Many investors will react to this by looking for the lowest expense funds that they can find and throwing their money into that. This knee-jerk reaction is understandable, but it comes with its own risks. Lower-expense funds are often cheap because they do not involve any kind of direct diversification or risk management strategies. Sometimes, a higher expense ratio makes sense for an investor’s time horizon, risk tolerance, and strategy. Many times, investors will want to combine lower and higher expense-ratio funds to match the diversification and investment goals of the investor.
The key here is to invest with expense ratios in mind, while being guided by a more comprehensive understanding of the market and your own investment goals.
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