Expense Ratio: The Mutual Fund Stat You Can't Afford to Ignore

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One of the great selling points of mutual funds is that they're fire-and-forget investment vehicles. You make your contributions, and then check in on your fund's performance every once in a while, secure in the knowledge you're diversified across a wide range of stocks, bonds or both.

The flip side of fire-and-forget is that most mutual-fund investors probably don't look too closely at the critical details of their investments, like their fund expenses. These fees eat into returns and can add up to significant amounts. Happily, there's an easy way to compare these parasitic costs across different funds.

Your Friend, the Expense Ratio

As with any other kind of enterprise, a mutual fund needs money to operate. Costs can include administrative fees, taxes, marketing fees, legal expenses and securities transaction fees. But a mutual fund's biggest operating cost is typically the investment advisory fee -- the money paid to the fund's investment manager.

All of these costs have to be paid by someone, and that someone is you, one of the fund's many investors. The lower the operating costs, the better your returns. And the easiest way to compare operating costs across funds is with the "expense ratio."

The expense ratio is arrived at by dividing the fund's operating costs by its average assets, and it is expressed as a percentage. For example, the expense ratio of my Vanguard 500 Index Fund Admiral Class (VTSAX) is 0.05 percent. This means only 0.05 percent a year of the fund's total assets are paid to those who run it. A lower expense ratio leads to a better long-term performance.

The Numbers Don't Lie

Last year, Financial Analysts Journal published a paper by William F. Sharpe titled "The Arithmetic of Investment Expenses." Sharpe is professor emeritus of finance at Stanford University and the 1990 Nobel Prize in Economics. In the study, he compared two investments: one made in a fund with high operating costs and the other in a fund with low operating costs. The low-cost fund was a Vanguard Total Stock Market Index Fund Admiral Shares, and had an expense ratio of 0.06 percent a year. The high-cost fund had an expense ratio of 1.12 percent a year, which Sharpe said is the average for such funds.

%VIRTUAL-article-sponsoredlinks%The differences were startling. Over a period of 10 years, the fees on an investment of $10,000 were only $153 with the low-cost Vanguard fund, compared to $2,720 for the high-cost fund. But far more important were the effects high operating costs have on fund returns over the long run. Again over a 10-year period, an investor in the low-cost fund ends up with 11.25 percent more wealth than an investor in the high-cost fund -- all because of higher operating costs.

"A person saving for retirement who chooses low-cost investments," Sharpe says, "could have a standard of living throughout retirement more than 20 percent higher than that of a comparable investor in high-cost investments."

The funds being compared were index funds designed to simply track a benchmark. My Vanguard fund, for instance, mimics the S&P 500 (^GPSC). While there is almost certainly a human looking after things at my fund, that person isn't moving stocks in and out of it at his or her personal discretion. Not only would I have to pay extra for that, but I would also have to bear the costs such moves would generate.

Say It With Me Now: Expense Ratios

In his paper, Sharpe quotes a director of fund research at Morningstar (MORN), which provides mutual-fund analysis and data: "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision. ... They are still the most dependable predictor of performance."

Any investment house worthy of your money should be proud of its low-cost, high-return fund offerings. However you monitor your mutual fund's performance, the expense ratio should be easy to find. And if it isn't, you may want to ask yourself -- and the company offering the fund -- why.

Expense Ratio: The Mutual Fund Stat You Can't Afford to Ignore
"Your daily habits and routines are the reason you got into this mess," writes Trent Hamm, founder of TheSimpleDollar.com. "Spend some time thinking about how you spend money each day, each week and each month." Do you really need your daily latte? Can you bring your lunch to work instead of buying it four times a week? Ask yourself: What can I change without sacrificing my lifestyle too much? 
Remove all credit cards from your wallet and leave them at home when you go shopping, advises WiseBread contributor Sabah Karimi. “Even if you earn cash back or other rewards with credit card purchases, stop spending with your credit cards until you have your finances under control,” she writes.
If you do a lot of online shopping at one retailer, you may have stored your credit card information on the site to make the checkout process easier. But that also makes it easier to charge items you don't need. So clear that information. "If you’re paying for a recurring service, use a debit card issued from a major credit card service linked to your checking account," Hamm writes.  
Reward yourself when you reach debt payoff goals. "The only way to completely pay off your credit card debt is to keep at it, and to do that, you must keep yourself motivated," Bakke writes. Just make sure to reward yourself within reason. For example, instead of a weeklong vacation, plan a weekend camping trip. "If you aim to reduce your credit card debt from $10,000 to $5,000 in two months," Bakke writes, "give yourself more than a pat on the back." 
“Establish a budget,” writes Money Crashers contributor David Bakke. “If you don't scale back your spending, you'll dig yourself into a deeper hole." You can use personal finance tools like Mint.com, or make your own Excel spreadsheet that includes your monthly income and expenses. Then scrutinize those budget categories to see where you can cut costs.    
Sort your credit card interest rates from highest to lowest, then tackle the card with the highest rate first. "By paying off the balance with the highest interest first, you increase your payment on the credit card with the highest annual percentage rate while continuing to make the minimum payment on the rest of your credit cards," writes Mint.com spokeswoman Hitha Prabhakar.
To make a dent in your debt, you need to pay more than the minimum balance on your credit card statements each month. "Paying the minimum -– usually 2 to 3 percent of the outstanding balance -– only prolongs a debt payoff strategy," Prabhakar writes. "Strengthen your commitment to pay everything off by making weekly, instead of monthly, payments." Or if your minimum payment is $100, try doubling it and paying off $200 or more. 
If you have a high-interest card with a balance that you’re confident you can pay off in a few months, Hamm recommends moving the debt to a card that offers a zero-interest balance transfer. "You’ll need to pay off the debt before the balance transfer expires, or else you’re often hit with a much higher interest rate," he warns. "If you do it carefully, you can save hundreds on interest this way."
Have any birthday gifts or old wedding presents collecting dust in your closet? Look for items you can sell on eBay or Craigslist. "Do some research to make sure you list these items at a fair and reasonable price," Karimi writes. “Take quality photos, and write an attention-grabbing headline and description to sell the item as quickly as possible." Any profits from sales should go toward your debt. 
If you receive a job bonus around the holidays or during the year, allocate that money toward your debt payoff plan. "Avoid the temptation to spend that bonus on a vacation or other luxury purchase," Karimi writes. It’s more important to fix your financial situation than own the latest designer bag.
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