Understand Expense Ratio

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CWRadio
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Understand Expense Ratio

Post by CWRadio » Sun Jan 14, 2018 9:20 am

Trying to clarify how Expense Ratio affect my holdings.
Example
I have two funds.
First fund has a Expense Ratio of 0.10%.(fund one)
Second fund has a Expense Ratio of 1.00%. (fund two)
In the beginning of the year I put $1000 in each fund.
The return at the end of the year is 10%.
My question:
Which fund will have more money in it at the end of the year, fund one or fund two?
Thanks Paul

Jack FFR1846
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Re: Understand Expense Ratio

Post by Jack FFR1846 » Sun Jan 14, 2018 9:28 am

The expense ratio is taken out from earnings throughout the year (daily?) so you don't directly see it as a line item on your statements.

I'm going to ignore that fact (accountants here can figure that out with a simple formula, I'm sure) and say that you get your gains on the last day of the year.

So fund #1 gains $100. The ER of 0.1% reduces this by 0.1/100 * 1000 or $1, so your new balance is $1000+100-1 or $1099.

Fund #1 also gains $100. The ER of 1% reduces this by 1/100 * 1000 or $10, so your new balance is $1000+100-10 or $1090.
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oldcomputerguy
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Re: Understand Expense Ratio

Post by oldcomputerguy » Sun Jan 14, 2018 9:33 am

Well, it depends.

When looking at past returns of a fund, those numbers are typically reported after expenses. So if you looked at two fund that both quote a 10% return to the fund shareholder, then that 10% is after the expenses were taken out. If the ER of one fund is higher than the other, but they still both quote a 10% return to the fund shareholder, then this implies that the holdings in one fund actually did better that year than those in the other fund, but the better performance of the holdings was counteracted by the higher expense of the fund itself.

In your example, if the two funds' holdings performed the same but the ER of one fund is higher, than the return you see as a fund shareholder will be correspondingly different.

This becomes important when choosing a fund based on asset class. The Fama-French model predicts that the majority of influence on your investment's return depends on what asset class you are investing in, rather than on the specific choices of funds. For example, if you have a choice between two large-cap blend funds, then Fama-French says that their returns before expenses will be similar (maybe very, very similar) because they both invest in the same asset class.

Why is this important? Because if you are contemplating the choice between two large-cap blend funds, one with a 0.1% ER and one with a 1.0% ER, chances are that you as a shareholder will see better final return from the fund with the lower ER. That is because the two funds likely will have similar returns from their respective holdings, but the fund with the lower ER will take a smaller share out for itself before passing those returns on to you.

Hope this helps.
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Bob-a-job
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Re: Understand Expense Ratio

Post by Bob-a-job » Sun Jan 14, 2018 9:34 am

performance is based on the net profits a fund can provide shareholders. Net profit is based on investment gains less expenses.
Therefore returns are always quoted after expenses have been deducted.

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jhfenton
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Re: Understand Expense Ratio

Post by jhfenton » Sun Jan 14, 2018 9:34 am

The returns you see show up in the price of the fund are after expenses. Mutual funds are not allowed to report performance before expenses.

Let's say you invest $1,000 in two funds with identical holdings (say the S&P 500), and those holdings return 10% over the next year. Fund A, with an ER of 0.10% would be worth $1,099. Fund B, with an ER of 1.00% would be worth $1,090. (That's ignoring trading costs. An S&P 500 fund would have low trading costs. An active fund trading a lot would have higher invisible costs. The expense ratio also ignores any revenue that the fund earns from lending out its securities. For small cap funds in particular, that can add up to a large invisible subsidy.)

You never see the expenses being deducted. They come out of the NAV silently on a daily basis over the course of the year.

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Re: Understand Expense Ratio

Post by BogleMelon » Sun Jan 14, 2018 9:36 am

Fund one is better (assuming both have exactly same returns)
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dm200
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Re: Understand Expense Ratio

Post by dm200 » Sun Jan 14, 2018 10:15 am

CWRadio wrote:
Sun Jan 14, 2018 9:20 am
Trying to clarify how Expense Ratio affect my holdings.
Example
I have two funds.
First fund has a Expense Ratio of 0.10%.(fund one)
Second fund has a Expense Ratio of 1.00%. (fund two)
In the beginning of the year I put $1000 in each fund.
The return at the end of the year is 10%.
My question:
Which fund will have more money in it at the end of the year, fund one or fund two?
Thanks Paul
No way to know. If the underlying holdings of fund two significantly outperform the holdings of fund one, then fund two may have more. Your example, in my opinion clarfies nothing.

dbr
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Re: Understand Expense Ratio

Post by dbr » Sun Jan 14, 2018 10:58 am

I read the post to say that the return for the year of each fund is 10%. That is the same statement as saying that starting with the same amount of money in each fund the two funds will also have the same amount of money at the end of the year, namely 10% more than started with.

Either there is a misunderstanding of the definition of return or the question is not what it seems to be.

Any clarification?

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dm200
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Re: Understand Expense Ratio

Post by dm200 » Sun Jan 14, 2018 11:01 am

dbr wrote:
Sun Jan 14, 2018 10:58 am
I read the post to say that the return for the year of each fund is 10%. That is the same statement as saying that starting with the same amount of money in each fund the two funds will also have the same amount of money at the end of the year, namely 10% more than started with.

Either there is a misunderstanding of the definition of return or the question is not what it seems to be.

Any clarification?
OK, missed that.

Not clear what 10% return means to OP

dbr
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Re: Understand Expense Ratio

Post by dbr » Sun Jan 14, 2018 11:08 am

dm200 wrote:
Sun Jan 14, 2018 11:01 am
dbr wrote:
Sun Jan 14, 2018 10:58 am
I read the post to say that the return for the year of each fund is 10%. That is the same statement as saying that starting with the same amount of money in each fund the two funds will also have the same amount of money at the end of the year, namely 10% more than started with.

Either there is a misunderstanding of the definition of return or the question is not what it seems to be.

Any clarification?
OK, missed that.

Not clear what 10% return means to OP
I would speculate that the OP means the investments in the two funds had the same returns or maybe are even exactly the same investments. In that case, with the information that holdings of a fund have to be liquidated to pay the costs of a fund, it would be obvious that there would be less wealth left in the more costly fund and that the return of that fund would be less than the return of the other one. We still have to wait and see what the point of the question actually is.

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dm200
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Re: Understand Expense Ratio

Post by dm200 » Sun Jan 14, 2018 11:10 am

I would speculate that the OP means the investments in the two funds had the same returns or maybe are even exactly the same investments. In that case, with the information that holdings of a fund have to be liquidated to pay the costs of a fund, it would be obvious that there would be less wealth left in the more costly fund and that the return of that fund would be less than the return of the other one. We still have to wait and see what the point of the question actually is.
Perhaps the OP can clarify the meaning of the "10%".

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CWRadio
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Re: Understand Expense Ratio

Post by CWRadio » Sun Jan 14, 2018 11:27 am

dm200 wrote:
Sun Jan 14, 2018 11:10 am
I would speculate that the OP means the investments in the two funds had the same returns or maybe are even exactly the same investments. In that case, with the information that holdings of a fund have to be liquidated to pay the costs of a fund, it would be obvious that there would be less wealth left in the more costly fund and that the return of that fund would be less than the return of the other one. We still have to wait and see what the point of the question actually is.
Perhaps the OP can clarify the meaning of the "10%".
Thank you all for answering my question on a Sunday morning.

The point of the original question was two of my my friends have the same type of fund (ex S&P 500) in their 401K. One friend had a higher expense ratio then the other. One works for a big company( 3000 people) and the other works for a small company(50 people)
They asked me which one of use would have more money at the end of the year in that fund, so I ask my friends at Boglehead.

Paul

dbr
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Re: Understand Expense Ratio

Post by dbr » Sun Jan 14, 2018 11:38 am

CWRadio wrote:
Sun Jan 14, 2018 11:27 am
dm200 wrote:
Sun Jan 14, 2018 11:10 am
I would speculate that the OP means the investments in the two funds had the same returns or maybe are even exactly the same investments. In that case, with the information that holdings of a fund have to be liquidated to pay the costs of a fund, it would be obvious that there would be less wealth left in the more costly fund and that the return of that fund would be less than the return of the other one. We still have to wait and see what the point of the question actually is.
Perhaps the OP can clarify the meaning of the "10%".
Thank you all for answering my question on a Sunday morning.

The point of the original question was two of my my friends have the same type of fund (ex S&P 500) in their 401K. One friend had a higher expense ratio then the other. One works for a big company( 3000 people) and the other works for a small company(50 people)
They asked me which one of use would have more money at the end of the year in that fund, so I ask my friends at Boglehead.

Paul
Good. The answer is that you will pay .1% of the assets you would otherwise have gained purely from gains in the S&P 500 to pay for the operation of the fund and your friend will pay that same .1% to operate his fund and in addition will have .9% of his assets taken away to pay his plan administrators, adviser, brokers, and what have you to run his plan. That is probably typical of the difference between large and small companies where large companies have better economy of scale and greater negotiating power to buy low cost plans. It is also possible the large company is subsidizing some plan costs and the small company is not.

As a quibble, that posted expense ratio does not include all sources of income and expense for the funds. Other items are trading costs inside the funds, income from security lending, and others. For an S&P 500 index fund those items should be negligible and 0.1% total expenses is probably high ballpark. There are 401k plans that use S&P 500 index funds with costs as low as 0.04%, even as low as 0.00% (I have heard reported). For awhile my 401k had an S&P 500 fund from SSgA that charged 0.01%.

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Earl Lemongrab
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Re: Understand Expense Ratio

Post by Earl Lemongrab » Sun Jan 14, 2018 1:55 pm

One way to see is to compare two otherwise identical funds with different ERs. That's easy because of the different share classes of Vanguard funds. The link below has a comparison between the Investor and Admiral shares of the 500 fund:

Chart

It's ten-year, but you can adjust the endpoints how you like. It's important to use total return, as expenses come out of dividends. You can see the difference in return over that time:

VFINX:24,399.84
VFIAX:24,667.95
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dm200
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Re: Understand Expense Ratio

Post by dm200 » Sun Jan 14, 2018 5:07 pm

With employer 401k or 403b plans, not also that there may be added fees/ratios beyond the stated expense ratio of the mutual fund. Such added fees may be deeply buried and difficult to find the truth in the documents.

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