The expense ratio of funds matters. Back in 2010, Morningstar found that the best predictor of future returns was a low expense ratio. This beat every other indicator, including Morningstar stars.

This makes sense. By default, we would expect that a fund which perfectly tracks its index will underperform the index by its expense ratio. For example, if the S&P 500 Index achieved a 5.00% return for the year and the fund’s annual expense ratio is 0.05%, a fund perfectly tracking the index would have achieved 5.00% return and then taken 0.05% in expenses for a fund return of 4.95%.

And indeed, when we look at fund performance this trend line proves fairly accurate.

In order to illustrate this, I analyzed the over or under performance of annual returns for over sixty S&P 500 Index funds over the last decade. I used Morningstar Advisor Workstation to get the 2023 expense ratio from the fund’s annual report as well as the fund’s calendar return from 2013 through 2022.

For each fund and each year, I calculated the net advantage of the fund over the S&P 500 Index overall by subtracting the return of the S&P 500 for that year from the relevant fund for that year. Then, I calculated the trendline for the fund’s performance compared to the fund’s expense ratio.

As you can see in the below graph, the expected return representing underperformance equal to the expense ratio and the calculated trendline are near identical. One reason for the variation is likely that some of the now inexpensive funds may have had a higher expense ratio over some part of the last decade.

Regardless, this simple example still demonstrates the importance of expense ratio.

In our opinion, the expense ratio for a S&P 500 Index fund should be less than 0.04%. On the graph, this is the left half of the first column.

The fact that there are any fund companies operating a S&P 500 Index fund with expense ratios over 0.20% (over five times what it could cost) is remarkable. The fact that investors pay such high expense ratios without knowing or caring is also remarkable.

Expense ratios matter. For index funds, the lower the expense ratio, generally the higher the return. For a client with $300,000 of assets growing at 6%, having an expense ratio of 0.40% instead of an expense ratio of 0.04% costs over $264,000 during 30 years of investing.

As an investment committee, we are careful when selecting funds. We strive to ensure that we either pick the cheaper fund or we have a compelling reason to use the higher cost one.

You too should be careful to choose low cost funds for your portfolio.

Photo by Dang Cuong on Unsplash. Image has been cropped.