Expenses play an important role for almost all investors. If you invest in mutual funds, index funds, or ETFs, you’re paying a fee to the investment company. These fees are built into the overall return, so they aren’t always readily apparent, but they do affect your return. The higher the fee, the greater the drag on your return, and the less money you’ll make over time.
So, with many experts suggesting mutual fund expenses will soon be on the rise, it can be a cause for concern for investors. For the past few years, the general trend was a steady decrease in fund expenses. Expense ratios peaked in 2003 and have steadily declined since then. Unfortunately, the past five years of reduced costs may be coming to an end.
Why Funds May Increase Expenses
Every fund costs money to operate. You have fixed company costs, managers to pay, call centers to staff, and websites to maintain. In order to pay for everything involved with running an investment company, you need to generate income. So, funds charge a fee based on a percentage. Some funds charge only a fraction of a percent, while others may charge well over 1% per year.
As money flows into these funds, ,the amount of revenue increases, and since many expenses are fixed costs that don’t necessarily increase with assets under management, the fund company can trim their expense ratios and still generate enough income. Since 2003, that is exactly what has happened. Money has flooded into investments, particularly stock funds, so investment companies were able to continue cutting expenses. Unfortunately, this year has been different. With most stock funds losing 40% or more, and even more people fleeing stock funds for safer investments, these companies are now faced with the possibility of coming up short in income generated from the fees.
When companies struggle to generate enough income, they may have no other choice but to begin increasing their expense ratios. It will likely first affect smaller companies with fewer assets that don’t have the flexibility to weather these difficult economic times, but many experts believe it will begin to affect even the largest firms.
How Much of an Increase Can You Expect?
Estimates differ, but for most stock funds, you’re probably looking at anywhere between a 0.05 and 0.2% increase. Bond funds may also see an increase, but more than likely, they will be negligible. A 0.1% increase doesn’t sound like a lot, and it is a pretty small number. But when you consider the fact that this economic downturn probably won’t quickly turn around, these small increases may occur on a regular basis for the next few years, which could add up to a relatively large increase.
What Should an Investor Do?
In the grand scheme of things, there isn’t much you can do, but you do need to pay attention to what’s going on with your investments. If a fund is going to increase fees, whether you like it or not, it’s probably going to happen. This doesn’t mean that if one of your funds is announcing an increase that you should immediately go somewhere else, but you do want to make sure you’re minimizing fees everywhere you can. This is why it’s important to start off by investing in low-fee funds right from the start, so that fee increases like this won’t have as much of an impact on your bottom line.
One area that this may impact is in retirement plans such as 401(k)s. As plan administrators review their plan’s investment options, changes in fees from one firm to another may lead to a fund lineup change in your plan. Or even worse, your plan administrator may be oblivious to fees completely, and your offerings may get hit harder by these increases. In cases like this, you’d want to bring it to their attention in an attempt to obtain better fund choices within your plan.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
Art, that's because NAV already has the expenses built into the price. So it's true that if you buy a fund at $10 and sell it at $11, that's a 10% gain no matter how you look at it. But what isn't easily revealed is that every day when NAV is calculated, a fraction of the ongoing expenses are reflected in that price. So you aren't taking a percentage off the top or anything, it's all calculated internally.
That's why it can be a little misleading when you're comparing funds. All of the reported gains and losses you see are real rates of return after expenses. So Fund A could have had a 10% return last year and Fund B could have also had a return of 10% last year, but fund A may have only had a 0.8% annual expense and Fund B may have had a 1.1% annual expense. Your net gain is identical regardless of the fund's expenses, it's just that fund B did a little better performance wise so that it offset the slightly higher expenses.
The only way to really see the effect is if you had two different funds that had EXACTLY the same holdings and different expense ratios. There, the performance should be off only by the difference in expenses. The problem is, there really aren't any funds that are identical. Even if you're talking index funds that track the same exact stocks, little things such as when the fund places trades, or how they weight their index, apply dividends, etc. can tweak performance by a couple basis points either way. But as a whole, the lower the expenses of the fund, the lower performance it has to see to match a similar fund with higher expenses to offset.
I'd like to understand how mutual fund expense ratios affect fund performance. If, for example, a no load fund is bought at NAV and sold at NAV and NAV equals the asset value of the underlying stocks less fund expenses, I don't understand how the expense ratio has any effect on the fund's percentage gain or loss. If I buy a fund for $99 ($100 underlying stock value less 1% expense ratio) and sell it for $148.50 ($150 underlying stock value less 1% expense ration), I realize a 50% gain which is the same gain as the underlying stocks. Either the no load fund is not both bought and sold at NAV or something else is going on that I don't understand.
I hadn't thought about this, but it certainly makes sense. I try to keep my investments in index funds whenever possible. But as you mentioned, there are many 401k plans that don't have that option.
Thanks for alerting us to this- I would never have thought about it, but it definitely makes sense. Will have to keep an eye on my mutual funds to see if any increase would precipitate a change in funds.- On the other hand, the company's fixed expenses might go down if they have less employees due to layoffs ;)
I was just deciding to buy some mutual funds a few days ago and I stumbled on this article. This definitely keeps me on my feet.