Watch Those Fund Fees

If the recent uptick in the market has you thinking about getting back into mutual funds, what’s the one important question you should ask? If you plan to hold the fund for more than a few years, don’t ask about past performance, ask about expenses. If a fund has lost 30% to 40% over the past year, the difference between the 1.5% expense ratio for the average equity mutual fund and the bare minimum ratios available with some index funds may not seem like a lot, but it can add up over the long term.

Index funds come by their rock-bottom expense ratios by limiting turnover and keeping management fees low. For the average stock fund, the management fee can be as much as 1% of the assets in the fund. It doesn’t matter if the fund does well or if it tanks, the fund manager still gets paid. In fact, if the fund does well, it will cost you more to own the fund, as the 1.5% slice of expenses is cut from a larger pie.

Putting the expense ratio issue into hard numbers can give you an idea of how much more a low-cost fund can earn you over the long term. Assuming the market returns to a fairly modest 8% annual yield, a $10,000 investment in an index fund with a 0.18% expense ratio would be worth $21,232 in 10 years, compared to a net value of $18,771 in a fund with a 1.5% expense ratio. With $100,000 or more to put into a fund, you could buy into an index fund with an expense ratio as low as 0.08%. Over 10 years, the difference in yield over the average stock fund would then be more than $26,500. For an easy way to compare fund results, use the SEC’s mutual fund expense calculator.