How fees and investing are related
The science of behavioral economics can help explain why we think the higher the price, the higher the value. There’s a term called “quality theory” that says people often assume a higher price indicates better quality and a higher long-term return on investment.
But it isn’t always the case. Let’s look at how this theory applies to index funds. Index funds are all similar in terms of how they work and how they’re constructed, yet their fees vary widely depending on the asset manager.
Morningstar offers the following example:
A study on index fund fees showed that there are large levels of fee variation among S&P 500 index funds that are virtually identical in most relevant characteristics. RYSPX and SWPPX, for example, are two S&P 500 index funds with a holding similarity score of 99.99 percent. [3]
Over the past 20 years, based on current fees, if you had invested $10,000 in RSPYX you would have paid $4,475.32 in total fees. On the other hand, if you had invested $10,000 in SWPPX over the same period, you would have paid $101.30 in total fees. This massive difference cannot be attributed to differing underlying characteristics because the two funds share almost identical portfolios. Then what explains the difference? Probably a high expense ratio.
Don’t be fooled by “small” fees
One problem that arises when comparing fees that funds charge, is that said fee amounts can appear to be small, with percentages ranging from 0.50% to 1.0% and 2.0%. But these seemingly small differences can make a huge impact on your savings over time.
Make sure to look at the fees you’re paying on the funds you’re investing in. If you realize you’re paying too much in fees, consider making a change.
Compare the funds’ expense ratios
The expense ratio is the annual cost paid to fund managers by holders of mutual funds or ETFs. The expense ratio for mutual funds is typically higher than expense ratios for ETFs. [1]
What is considered a high expense ratio?
What’s reasonable? According to CNN Money, it depends on the kind of fund. Index funds should have the lowest fees because they cost relatively little to run. For example, you can easily find an S&P 500 index fund with an expense ratio of less than 0.2%. For mutual funds that invest in large U.S. companies, look for an expense ratio of no more than 1%. And for funds that invest in small or international companies, which typically require more research, look for an expense ratio of no more than 1.25%. [2]
[1] https://tickertape.tdameritrade.com/investing/fund-expense-ratios-17570
[2] https://money.cnn.com/retirement/guide/investing_mutualfunds.moneymag/index14.htm
[3] http://cff.handels.gu.se/digitalAssets/1561/1561456_halling-paper.pdf
[4] All figures in 2012 dollars. Workers are assumed to begin saving at age 25 and retire at age 67. Example reflects median salary of $30,502 when worker starts saving at age 25. Example provided by CAP.
