FINANCIAL FRESHMAN #031
TL;DR → All pooled assets, such as ETFs or TDFs, will charge an expense ratio that represents the cost to manage that fund for one year. Over time these expenses can really stack up, which in turn will hinder the gains of your portfolio. Especially if you’re enrolling in a 401(k) for the first time, make sure you are mindful of the expense ratios of the available investment offerings.
The Cost of Investing
We’ve talked about investing a fair amount on this blog. If you are offered a 401(k) plan after college, we’ve written posts that you may want to read before you commit a percentage of your income. Aside from anything sponsored by your future employer, we’ve also discussed Target Date Funds and Index Funds, too.
Regardless of which investment vehicles you leverage in your adult life, and which financial servicer you use to invest in them, one thing will remain true. These investments will cost money. Since we haven’t explicitly covered this before, we’ll use this post to discuss what expense ratios are, how to find them for a specific investment, and what impact they may have on your financial future.
As with most things on this blog, gathering this knowledge in your 20s will be much more beneficial than if you’re in the dark until your 50s.
What is an Expense Ratio?
The obvious place for us to start…what is an expense ratio, anyway? Here is a simple definition to serve as a foundation.
In this context, we use the word “pooled” to mean essentially any investment other than individual stocks, or alternative investments like real estate or cryptocurrency.
Pooled investments let you buy a group of assets at once, like index funds, target-date funds, or exchange-traded funds (ETFs). When an asset is made up of a pool of several assets, it requires some type of management in order to remain on the market. That management could be active or passive, but the expense ratio pays for that management either way.
Finding an Expense Ratio
Fairly simple so far, right? We know what an expense ratio is, now let’s find them.
You could dig into a specific investment’s fund prospectus to figure out its expense ratio, but there are certainly easier ways. Depending on the financial servicer you leverage for your investments, the expense ratios could also be front and center on their app or website. In case this isn’t true, know that you can easily use the Fund Analyzer by the Financial Industry Regulatory Authority, or FINRA. Let’s use this tool to check out a few expense ratios. To search, all we’ll need is the ticker associated with the investment of interest.
Vanguard S&P 500 ETF (Ticker: VOO)
In the “Annual Operating Expenses” section, we can quickly see that this investment has an expense ratio of 0.03%. We can also gather that this investment is far less expensive than other ETFs available on the market.
Vanguard Target Retirement 2070 Fund (Ticker: VSVNX)
Assume that your future company offers a 401(k) plan that offers Vanguard TDFs, and you’d like to invest in their 2070 fund. Using the same tool, we see that this fund has an expense ratio of 0.08%.
Loomis Sayles Growth Fund Class N (Ticker: LGRNX)
Let’s check one more! Using the same 401(k) as an example, let’s assume that some growth funds are also offered. Loomis Sayles growth funds are common, so we’ve pulled the data on one of those below. Not good news here, as we can quickly see that our leading 0 within our expense ratio percentage is gone. With an expense ratio of 0.58%, this fund is over nineteen times more expensive than our ETF that tracks the S&P 500. Ouch.
So…Why Care?
We kicked off this post by mentioning that gathering this knowledge in your 20s could be immensely valuable. The thought of putting your retirement savings on autopilot while leveraging an incredibly expensive investment is a little bit scary to think about. Let’s prove this with some numbers.
As always, we’ll make some assumptions to keep the math easy.
Using this investment, let’s run the numbers using six total expense ratios: 0% (as a baseline), 0.05%, 0.10%, 0.25%, 0.50%, and 1.00%.
See the summary table below.
Choosing an investment with an expense ratio of 1% results in paying $140,000 more in fees compared to an investment with an expense ratio of 0.05%. The compounding impact of these fees results in a total balance at age 65 that is over $345,000 less.
Final Thoughts
When it comes to expense ratios, obviously you’ll be better off the lower the percentage is. There are assets out there with absolutely absurd expense ratios, including several funds with ratios exceeding 5%. It’s unlikely you’ll encounter any this high, but the range of expense ratios across the investment options within your 401(k) may surprise you.
Hopefully this post—and the math within it—will make you pause and take a look!
