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?

1. $500
2. $5,000.00
3. $8,252.35
4. $9,001.39

Solution

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.

This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.

The information presented by WrapManager, Inc. is general information only and does not represent tax or legal advice, either expressed or implied. You are encouraged to seek professional tax advice for income tax questions and assistance. WrapManager, Inc. does not advise on any income tax requirements or issues.