In the world of investing, the most popular thing to focus on is the rate of return. A typical investor may ask themselves, “How did I do versus my neighbor or the S&P 500?” Sadly, this is a question a lot of advisors ask themselves too.
While I have a lot to say about this (maybe I will cover this in a future blog post), today I want to focus on something very few investors or financial advisors talk about: hidden cost. Specifically the most prevalent hidden cost, the expense ratio.
What Is an Expense Ratio?
The expense ratio measures how much of a fund’s assets are used to cover all of the administrative and other operating expenses of a fund. These expenses include but are not limited to portfolio management, marketing, and distribution.
As I mentioned, most mutual funds and ETFs have expense ratios. They are not bad in and of themselves. In writing this, I hope to leave you with a desire to learn more about the investments you own as well as the underlying cost to own them.
Why Should I Care?
The average expense ratio across all advisor managed portfolios is 0.54%1. That means that for every $10,000 of money invested, the investor is paying $54. A person with $1MM invested would be paying an additional $5,400 annually on top of the fee they are paying their advisor which is most likely somewhere around 1.0%.
As you can see, this cost can be significant. If you pay that out over 20, 30, or 40 years, you can imagine the impact it could have on your future.
Why So High?
The cost to manage a fund varies widely. Some fund families like Vanguard have an average cost of 0.10% while others are significantly higher than the 0.54%. There are several reasons for determining how high the expense ratio is, but the primary reason is how the fund is managed. Mutual funds and ETFs can be actively or passively managed.
At a high level, actively managed funds have a goal of outperforming a given market or benchmark such as the S&P 500 Index. Passively managed funds simply mimic or track an index, like the S&P 500.
Actively managed funds are traded much more than passive funds to try and beat the market. This brings with it more risk and more cost. That additional cost is the difference in the expense ratio.
Is It Worth It?
This is a question that can’t be answered in a blog post. You and your advisor should talk about this and how it applies to your situation. One major thing to consider when having that conversation is what are the tax consequences of holding actively managed funds. This is something to consider if you have a significant amount of your net worth in a taxable account. Another thing to consider is whether or not the active fund you own is actually actively managed or a passive fund in an active wrapper2.
You have to decide what is right for you and your goals. I hope this has piqued your interest enough to at least explore what you currently own, make sure you understand it, and you feel it aligns with what you’re hoping to accomplish.