What “Fund Expenses” Really Mean For Your Returns

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I get a lot of questions about fund expenses. It usually occurs when I recommend a new fund, and I get something like, “What do you think about the 2% expense rate?” Many investors have misconceptions about fund expenses.

So let me explain – because they can matter much less than people think…

The discussion about expenses began with the advent of index-tracking mutual funds and exchange-traded fund (ETFs) in the 1970s and 1980s. The theory was that since actively managed funds generally didn’t outperform the broad market index mutual funds, index-tracking funds with very low expense ratios would outperform the average actively managed funds over the long term.

For reference, actively managed funds have annual expenses of 1.0% of assets or higher.

Index funds (mutual or ETF) track a specified index, such as the S&P 500. They own shares to match the index weighting, so no portfolio management is involved. These funds have expenses starting below 0.10%, depending on the tracked index. At this level, we are talking about basis points or 1/100^th of a percentage point.

Index fund sponsors compete on differences of a few basis points.

Fund marketers like to push low expense ratios as a path to above-average returns. They often make it sound as if investors pay expenses directly. For example, if someone owns a fund with a 1% expense rate, the fund or their broker will take 1% of the fund value at some point.

That belief is not accurate. Investors do not directly pay the expenses quoted for a fund, either index or actively managed.

Fund returns are always net of expenses. Put another way; the expenses are already included in the results published by a fund sponsor or in the results and returns you earn in your brokerage account.

I like to find and recommend actively managed ETFs that will outperform their passive, index-tracking competitors.

MLP funds are a good example. The Alerian MLP ETF (AMLP) tracks the Alerian MLP index and has an expense ratio of 0.85%. The InfraCap MLP ETF (AMZA) is actively managed and has expenses of 1.64%.

MLPs have performed very well for the last few years. Over the previous three years, since January 1, 2021, AMLP posted a total return of 119%. For the same period, AMZA was up 156%. It was worth it, and then some, to invest in AMZA despite its higher expenses.

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