The Problem with Focusing on Expense Ratios

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This article originally appeared on ETF.COM here.

The evidence is clear that investors are waking up to the fact that, while the past performance of actively managed mutual funds has no value as a predictor of future performance, expense ratios dolower-cost funds persistently outperform higher-cost ones in the same asset class.

That has led many to choose passive strategies, such as indexing, when implementing investment plans because passive funds tend to have lower expense ratios. Within the broad category of passive investment strategies, index funds and ETFs tend to have the lowest expenses.

Most investors believe that all passively managed funds in the same asset class are virtual substitutes for one another (meaning they hold securities with the same risk/return characteristics). The result is that, when choosing the specific fund to use, their sole focus is on its expense ratio. That can be a mistake for a wide variety of reasons. The first is that expense ratios are not a mutual fund’s only expense.

The whelk

You may never have heard of a whelk. However, this little ocean creature can ruin an oyster’s day. A whelk looks like a conch, only a bit smaller. It’s equipped with a tentacle that works like an auger. The little whelk will drill a very small hole in the top of an oyster’s shell. Through this very small hole, a whelk can devour an entire oyster, sucking it out little by little until the oyster is gone.

Mutual fund expenses are like little whelks doing damage to your portfolio. A fund’s expense ratio tends to get the most scrutiny, but because it does not reflect all of a fund’s expenses, it can at times be a misleading indicator. In addition to a fund’s expense ratio, investors should consider trading costs (which include commissions), bid-offer spreads and market impact costs, which can be a problem even for index funds. The reason is that, to avoid what is called tracking error, they are forced to trade when stocks enter and leave the index they are replicating and active managers can front-run that trading.