What an expense ratio costs over ten years

What the number is

An expense ratio is the share of a fund's assets taken each year to pay for running it: management, administration, and other operating costs. It is quoted as a yearly percentage. A fund with an expense ratio of 0.50% takes $5 a year for every $1,000 you hold.

You never see a bill. The cost comes out of the fund's assets, so it shows up only as a slightly lower return. That is why it is easy to ignore.

Why small differences grow

The fee is charged on the whole balance every year, not only on what you put in. As the balance grows, so does the dollar amount of the fee. And every dollar paid in fees is a dollar that no longer compounds for you. Over one year the difference between two funds is a rounding error. Over ten years it is not.

Hypothetical numbers, worked through

Take $10,000, invested for 10 years, with an assumed return of 6% a year before fees. The 6% is an assumption for the arithmetic, not a forecast. Fund one charges 0.10% a year. Fund two charges 1.00%. To keep the arithmetic plain, subtract the expense ratio from the return each year: fund one grows at 5.90% a year, fund two at 5.00%.

After 10 years, fund one is worth about $17,740 and fund two about $16,289. The difference is about $1,451 on a starting amount of $10,000. The fee gap was 0.90 percentage points a year. Its cost came to more than 14% of what you started with.

That result holds for these assumptions only. A higher return assumption, a longer period, or a larger balance makes the gap larger in dollars; a lower one makes it smaller. The direction does not change: the cheaper fund keeps more of whatever the market gives both of them.

When two funds do the same job

Cost matters most when two funds are otherwise alike. Two index funds that track the same index hold nearly the same securities, so their returns before fees should be close. What separates them is mostly cost, plus how closely each follows the index.

So when you compare two ETFs on the same index, start with the expense ratio. Then check tracking difference: how far the fund's return has strayed from the return of the index it follows. A cheap fund that tracks poorly can give back what it saved you.

For actively managed funds the comparison is harder. A higher fee buys a manager's choices, and those choices may or may not add enough to cover the cost. The fee is certain. The added return is not.

What the ratio leaves out

The expense ratio is not every cost. Some funds charge a sales load, a commission when you buy or sell shares. Your brokerage may charge account or trading fees. A fund also pays trading costs inside its portfolio that the expense ratio does not include, and taxes are separate again. The fee table near the front of the fund's prospectus lists what the fund itself charges.

How IQ Dragon uses it

Expense efficiency is one of the five dimensions of the Dragon Score, weighted 20%. For Example fund A, a fictional US large-cap index ETF, it is the dimension that costs the score the most: it gives up 10.4 of its 20 points. Try your own amounts and fee levels in the calculator. It runs in your browser and sends nothing.