By Jack N., FocusShares® Communications Analyst and Blog Contributor
Cost matters because, in general, lower investment costs lead to higher returns. It also is perhaps the most obvious factor, and arguably the most important one, in explaining the explosive growth of exchange-traded funds (ETFs) over the last 15 years.
Why ETFs are Inexpensive
Most ETFs do not cost much for one reason: They’re run on a small budget, leading to lower expense ratios. The vast majority of ETFs don’t have to pay large teams of researchers and managers in an effort to beat market returns. That’s because they are passively managed, meaning they try to match as closely as possible key benchmarks, like the S&P 500 or the Morningstar® US Market IndexSM. By contrast, most mutual funds are actively managed, meaning they have added expenses for managers to find securities or to take positions that they think will lead to outperforming the indexes.
The expenses paid by ETFs and mutual funds are reported as an expense ratio, which is the total expenses divided by the number of shares outstanding. The average expense ratio paid by shareholders of U.S. equity mutual funds was 0.95 percent in 2010, according to the Investment Company Institute’s 2011 Fact Book. (The ICI is a trade association representing mutual funds, closed-ended funds, exchange-traded funds and unit investment trusts.) Separately, I calculated the average shareholder expense ratio for domestic equity ETFs at a far lower .23 percent. The 15 Focus™ Morningstar ETFs range from .05 percent to .19 percent.
Why Low Expense Ratios Matter
When investing, you should pay close attention to expense ratios because they directly reduce returns. For example, consider the .72 percent average expense ratio difference between mutual funds and ETFs. Hypothetically, assume that domestic securities grow by an average of 8 percent annually, excluding taxes and commissions. A $20,000 initial investment in the higher cost mutual fund would be worth $72,975 in 20 years. The lower-cost investment would be worth nearly $10,000 more, $82,888. For investors, who care about costs you might want to further explore expense ratios when you screen for ETFs and mutual funds.
You can find expense ratios in the prospectus of any mutual fund or ETF. Most funds make their prospectuses available on their websites. You might see both “net expense ratio” and “gross expense ratio” listed. The net expense ratio is the one that applies to shareholders.
To find out more about ETFs, visit Scottrade’s Knowledge Center, and to learn about FocusTMMorningstar ETFs, go to www.focusshares.com.
Next month we’ll look in more detail at active and passive investment styles.
How high of a priority do you place on expenses when deciding which ETFs or mutual funds to buy?
Jack N. has been with Scottrade since 2011. He is responsible for public relations for FocusShares®.