By timestaff
June 26, 2008

High expense ratios don’t necessarily mean better fund performance, but they do take a bite out of your overall returns.

Question: My wife and I have invested our Roth IRAs in a diversified mix of mutual funds. But it seems to me that the expense ratios of some of our funds are a little high compared to those of other similar funds. How much of an impact can expenses have on our returns in the long run? And what are acceptable expenses for different types of funds? —Curt M., Birmingham, Alabama

Answer: I don’t think there’s much doubt that a high expense ratio -which is the annual cost shareholders pay for a fund expressed as a percentage of the fund’s assets – can undercut performance, not to mention downsize your Roth accounts down the road.

To explain why that’s the case, I’ll use an analogy to a sport that I’ve been involved with for some 40 years: rowing.

If you’ve driven by a river or lake, you may have seen an eight-oared shell gliding gracefully along the surface of the water, the oars of the eight rowers moving in perfect synch.

You may have also noticed there’s a ninth person in the boat who doesn’t have an oar and isn’t pulling. That would be the coxswain, or “cox.” The cox’s main job is to steer, although as any cox will tell you without much prompting, they actually do a lot more, from directing the crew’s strategy during a race to serving as a sort of coach on the water.

What most distinguishes a cox from the rest of the crew – aside from the fact that they tend to be loud and bossy – is their size. They usually weigh 110 to 120 pounds. Which makes sense when you think about it. After all, the heavier the cox, the more weight the rowers have to pull down the course and, all else equal, the slower the boat will go.

So what does this have to do with mutual funds?

Well, just as a chubby cox can reduce boat speed, so too can a plump expense ratio weigh down a fund’s performance. The underlying stocks or bonds may be pulling for all they’re worth. But high expenses act as a drag that reduces shareholders’ returns.

Fund performance numbers bear this out. I revved up Morningstar’s Principia software program and screened for large-company blend stock funds that had been around at least fifteen years as of the end of May. (I chose a long period to filter out the noise and aberrations you might get over shorter time frames.)

I then compared the performance of funds in the top quartile of expenses (that is, funds with the highest expenses) to those in the bottom quartile (lowest expenses). What I found was that the high-expense group (average expense ratio: 1.78%) had an average 15-year annualized return of 8.42%, while the low-expense group (average expense ratio: 0.43%) had an average 15-year annualized return of 9.86%.

In short, the cheaper funds outperformed the costlier ones by an average of 1.44 percentage points a year, a margin very close to the 1.35 percentage-point difference in their annual expenses.

This is just one fund group over one period of time, of course. But former Vanguard chairman and fund-fee zealot John Bogle found much the same relationship after taking a much more extensive look at fund costs and performance in his book “Common Sense on Mutual Funds.” And Chris Jones, chief investment officer of 401(k) advice firm Financial Engines devotes an entire chapter (“How Fees Eat Your Lunch”) to the corrosive effect of high fees in his recently released book, “The Intelligent Portfolio.”

Does this mean that a fund with above-average expenses is doomed to lousy performance or that you’re assured superior results if you invest in low-expense funds?

No. there will always be exceptions, just as there are some coxswains whose superior racing savvy, motivational skills and intelligence may be able to compensate for a few extra pounds. But your odds of achieving higher returns certainly increase if you stick to funds with lower expenses and avoid ones with bloated expense ratios. Which means you’re also likely to end up with a larger account balance by opting for low-cost funds.

How much larger is hard to say, since that depends on what you’re paying for your funds now, how much you can pare that expense and what sort of performance you end up with. But boosting your return by even a quarter of a percentage point a year can increase the size of your nest egg considerably over the course of a career – not to mention reduce the chances that you’ll run out of money after you retire.

As for what’s an acceptable expense ratio, I can’t give you a definitive figure category by category. But if you go to Morningstar’s Fund Screener, you can screen for funds in a variety of categories with expense ratios below a certain threshold (2.0%, 1.5%, 1% or 0.5%). I’d start by screening for funds with the lowest expenses and, if I didn’t find anything worthwhile (that is, funds with a decent track record, acceptable minimum investment, risk level, etc.), I’d work my way up.

As you go through this process, you’ll also see at the bottom of the results page the average expense ratio for whichever fund category you’re screening. This will give you a sense of where a particular fund stands relative to its peers.

Or you could make things easy on yourself and start your search at the Money 70, our list of recommended funds. Along with other desirable qualities, all the funds on our list have annual expenses below their category average, while some sport the slimmest expense ratios around.

So I encourage you to see whether you can find comparable funds to the ones you own but with lower fees. It’s challenge enough to build a decent nest egg. Why make it harder by giving up more of your gains to fees than you have to?

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