ETF ACADEMY: The High Cost of Mutual Funds

One of the reasons that mutual funds will eventually go the way of VCRs, analog television and afternoon newspapers is their high cost.

According to the Securities and Exchange Commission publication Mutual Fund Investing – Look at More Than a Fund’s Past Performance, tip number one is to scrutinize the fund’s fees and expenses. Specifically,

A fund with high costs must perform better than a low-cost fund to generate the same returns for you.

Got it. However, the SEC goes on to say something even more meaningful:

Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858.

Coincidentally, the expense ratio of the typical ETF is in the 0.4% to 0.5% range – compare that to the expenses of your mutual funds. Here’s a quick and easy way.

The SEC recommends using FINRA‘s calculator to find out how much mutual funds are eating into the future value of your portfolio. We plugged in a couple of random large cap mutual funds and compared the expenses and future value against iShares S&P Global 100 Index Fund (NYSEArca: IOO).

Using conservative figures like a starting portfolio of $100,000 and an expected annual return of 7%, the difference in the ending values are breath taking.

Despite the assumption of identical investment returns, the ETF outperforms the first mutual fund by almost $50,000 and the second fund by $65,000 over a 20 year period. To avoid embarrassment, we disguised the names and tickers of the mutual funds which are both from well known fund-families.

Learn more about the Financial Industry Regulatory Authority (FINRA) here.

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