How Does An Expense Ratio Impact Returns?
Consider this scenario:
Your friend Martha has just invested $100,000 in a mutual fund that has an expense ratio of 1.50%. She has discovered an alternative investment that is very similar to the mutual fund she purchased but has an expense ratio of 1%. She is considering switching to the lower cost investment but isn’t sure if 50 basis points in an expense ratio will make much of a difference in her returns going forward.
Assume both investments return 8% per year, each year for the next 10 years before expenses.
What is the difference in ending dollar value between the mutual fund with an expense ratio of 1.5% and the alternative investment with an expense ratio of 1% at the end of 10 years?
D is the correct answer. Here's why:
Mutual fund with expense ratio of 1.5% = $100,000 x 1.06510 = $187,713.75 at the end of 10 years
Alternative investment with expense ratio of 1% = $100,000 x 1.0710 = $196,715.14 at the end of 10 years
Difference in returns = $196,715.14 - $187,713.75 = $9,001.39.
It is very likely that Martha will find it worth her time and effort to switch to the less expensive alternative. The more expensive mutual fund will end up costing Martha more than $9,000 in returns over 10 years.
Note that the difference in wealth accumulation compounds over time – as more time passes the difference in ending dollar value between the two options will grow larger and larger.
Martha should consider working with a financial advisor who can help her analyze variables such as expense ratios. Note that similar investments may still differ in performance and there is no guarantee that they will reach certain performance levels.
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