How Expense Ratios and Turnover Rates in Mutual Funds Will Erode Your Returns Over Time
When you’re trying to grow your retirement nest egg, every dollar counts. Even the smallest amounts can add up over time through compound interest. Unfortunately, many investors aren’t aware of how much money the mutual funds they’re using are losing each year.
High expense ratios and turnover rates may seem small when you originally invest, but they can slowly erode your returns over time. This could result in a significantly smaller nest egg, and more financial stress as you head into retirement.
Expense Ratios Impact Investments
If you’re an investor, you know all about how your investments gain compound interest over time. But did you know that the expenses your mutual funds incur also compound to have an increasingly negative impact on your portfolio over time?
Expense ratios are representative of what percentage of a fund’s assets are used to cover administrative and operating expenses. Typically, to calculate a mutual fund’s expense ratio, you divide the total fund costs by the total fund assets. The higher the fund costs are, the potential for lower returns for investors.
Mutual fund expense ratios typically max out at 2.5%. That may not sound like a significant amount of your total retirement savings. After all, 2.5% is a relatively small price to pay for a potentially high-performing mutual fund, right? The truth is that, as expenses slowly eat away at your earnings, you’re not just losing the percentage amount of the expense costs, you’re also losing all of the potential compound interest that those funds may have earned.
Let’s take a look at an example from Vanguard(1):
You have $100,000 invested for 25 years, earning an average of 6% each year. At the end of 25 years, you’ll have $430,000.
Now, imagine that $100,000 is subject to a 2% expense ratio. At the end of the 25-year investing period, you’d only have $260,000 in your nest egg after expenses.
The difference here is notable! When it comes to growing your retirement savings, trimming fees is a key part of keeping your earnings up as you head into this next chapter of your life. This is why at Retirement Matters, our goal is to have you in a globally diversified portfolio for the lowest cost possible.
Using Turnover Ratios to Estimate Fund Quality
Turnover rates are a little bit different than expense ratios but are still an important number to track. While an expense ratio is the amount that the fund company charges to run the mutual fund each year, turnover rates are the total number of transactions with the mutual fund holdings that happened over the course of a given year. You can also look at turnover rate percentages as a showing of how many of the fund’s assets changed in a year. For example, a 100% turnover rate means that all the positions in the mutual fund were sold at some point during the last year.
Higher turnover rates are a pretty good indicator that your mutual fund is going to cost you more money throughout the year. That’s because a high turnover rate indicates that a significant amount of trades are being made within your mutual fund. Every time assets are traded in your fund, you’re going to experience a taxable event. While this can be good, because more trades may mean more gains can be locked in, it also means a higher tax bill. When gains are recognized during each sale, you’re being taxed on those gains at a higher frequency, and if the investment has been held shorter than 12 months, it will result in a higher tax rate at which those gains are taxed.
Actively Traded Funds v. Passively Traded Funds
Typically, mutual funds with high turnover rates are being actively traded. Fund managers are trading regularly to adjust the assets in the fund, sometimes as much as multiple times a day. Many investors are drawn to active trading because, in theory, it could mean higher return rates. However, this isn’t always the case, largely due to the fees that actively traded funds incur.
In addition to higher taxes associated with a high turnover rate, actively traded funds also have higher management fees. Fund managers who manage an actively traded fund have to spend more time and attention performing trades, and zeroing in on every penny of profit they can possibly get out of a given day. That time spend comes back to the investor in the form of higher fund management expenses.
Passively traded funds, on the other hand, focus on slower, more focused trading. They spend a lot of time researching each trade, and carefully weigh the pros and cons of each trade against the fund’s long-term gains strategy. Passive investors also tend to allow small market fluctuations to play into their long-term plan. They may not trade an asset unless it falls significantly in a down market, and prefer to keep turnover rates (and, by association, expense ratios) low.
There are pros and cons to both actively managed and passively managed funds. However, as an investor, it’s easy to get wrapped up in an actively traded mutual fund without realizing the type of expenses you’re taking on.
At Retirement Matters, we believe that inaction can be a good thing. We make sure to find investments that have consistently low turnover ratios, and then in accounts that we manage, we also don’t make trades unless specifically warranted.
Know Your Fees
Keeping track of the fees and expenses that your investments are incurring can have a massive impact on your ability to save before retirement. Watching your expenses becomes even more important after you retire so that you can extend the life of your nest egg when you stop making regular contributions, and start tapping your savings for retirement income.
The good news is that you don’t have to manage the fees and expenses associated with your portfolio alone. As a fee-only financial planner, I help my clients create an investment strategy that takes expenses, tax planning, and their unique goals into account.
Want to learn more? Schedule a call with me today! I’m happy to chat with you about the expenses you’re dealing with in your current investment portfolio.