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ETF Expense Ratios: Their Impact on Long-Term Performance

Exchange-traded funds (ETFs) are commonly recognized as a low-cost way to achieve a diversified portfolio. That makes sense: because ETFs are passively managed, they don’t incur the research and analysis expenses borne by actively managed mutual funds. It’s important to keep in mind, though, that not all ETFs cost the same. In fact, some charge much higher fees than others.

Sometimes a larger expense ratio will be generated by a particular fund focus (such as foreign bonds) that may require the ETF sponsor to spend more money to operate. Other times you’ll find ETFs with identical objectives but different costs. For example, the SPDR S&P 500 ETF (SPY) tracks the same index as the iShares S&P 500 ETF (IVV) and the Vanguard S&P 500 ETF (VOO). However, SPDR’s fund has an expense ratio of 0.09%, while iShares charges 0.07%, and Vanguard is even less—at just 0.05%. Even so, these expense ratios are all low because they’re very basic products. They provide investors with exposure to the S&P 500, with no attempt to mitigate risk or actively manage the holdings in any way.

Paying for Complexity with ETFs

Funds that do more may also charge more. For instance, Invesco’s PowerShares BuyBack Achievers ETF (PKW) has a lot of holdings crossover with SPY, but its expense ratio is 0.68%, which is 7 – 13 times more expensive than the 3 S&P 500 ETFs listed above. Its expense ratio is a result of the complexity of the fund’s strategy, which involves screening for and purchasing companies that aggressively buy back shares of their own stock. Incidentally, shares of PKW have outperformed shares of SPY year-to-date, and over the past 1-year and 3-year periods.[1] But potential investors in this fund need to consider whether they believe this strategy provides a long-term advantage that justifies the higher level of annual expense.

The Hit from High ETF Expense Ratios

While a higher expense ratio may be needed to cover the more complex operational structure of certain ETFs, investors should understand how the compounding effect of those expenses, year after year, can dramatically impact returns.

Let’s assume an ETF returns 10% in a given year with an expense ratio of 0.5%. A $10,000 investment would net $950 profit to the investor. However, a fund with a would yield $800 profit.  That’s a big difference, but not a distressing one. In a single year, the extent to which that higher expense ratio will lower returns is relatively small.

What is distressing is what happens over time. If we average that 10% return over 10 years, our 0.5% expense ratio fund will be worth $24,782.28 by year 10. Our 2% expense ratio fund, however, will be worth only $21,589.25—a difference of over $3,000!

Assessing Portfolio Expenses

Some investors may react to higher ETF costs by immediately looking for lower-cost alternatives. This knee-jerk reaction is understandable but it may not always be the perfect solution.  The lower-cost funds may come with downsides of their own such as not providing the same level of risk mitigation strategies which some of pricier ETFs may provide.

When constructing a portfolio, it’s helpful to be aware of the fees and expenses which you’re exposed to within each of your investments.  With an awareness of what the compounding effect of those expenses can be, you can consider over time whether those expenses are worthwhile given the performance and risk profile of your various funds in both up and down markets.

[1] PKW Performance as of June 22, 2015: YTD=3.52%, 1-Year=11.76%, 2-Year=21.56% http://performance.morningstar.com/funds/etf/total-returns.action?t=PKW

SPY Performance as of June 22, 2015: YTD=3.02%, 1-Year=9.39%, 2-Year=18.01% http://performance.morningstar.com/funds/etf/total-returns.action?t=SPY

As calculated by Folio Investing using Morningstar’s Trailing Total Returns calculations.

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