Expense ratio explained: Why even a small difference matters

What is a good expense ratio?

Expense ratios vary depending on the type of fund, but benchmarks help identify whether a ratio is reasonable:

• Index funds. Generally considered cost-efficient if the expense ratio is below 0.2%, with some options as low as 0.03%.
• Actively managed funds. Acceptable expense ratios are typically under 1%, though they tend to be higher due to active stock selection and management costs.

To determine if an expense ratio is "good," compare it with similar funds in the same category. For example:

• An S&P 500 index fund with an expense ratio of 0.1% is competitive.
• An actively managed equity fund with a 1.2% ratio may be less attractive unless it consistently delivers superior returns.

You may want to avoid funds with excessively high expense ratios unless they justify costs through exceptional performance, which is rare.

How expense ratios impact long-term returns (example)

Even a small difference in expense ratios can lead to significant disparities in portfolio performance over time due to compounding. Here's an example:

Consider two investors, each starting with USD 100,000 and earning a 7% annual return before fees:

• Investor A chooses a fund with a 1% expense ratio.
• Investor B opts for a fund with a 0.2% expense ratio.

After 20 years and considering the compounding effect:

• Investor A's portfolio grows to approximately USD 320,713, reduced by USD 66,255 in fees over time.
• Investor B's portfolio grows to USD 372,756, saving USD 52,043 by choosing a low-cost fund.

Fees are subtracted from your returns every year, reducing the amount available for reinvestment. Over decades, this compounds into a substantial difference in final portfolio value. Lower expense ratios leave more money invested, maximising growth potential.

How to minimise the impact of expense ratios

Reducing the effect of expense ratios is essential for protecting your long-term investment returns. Minor cost differences can compound into significant sums over time, making it essential to take proactive steps.

Here are a few steps you can take:

Choose funds with low expense ratios

Prioritise funds with minimal expense ratios to maximise the investment amount remaining in play. Index funds and ETFs are often the most cost-effective options, with many charging less than 0.1%. These funds provide access to a broad range of markets without the high management costs of actively managed funds.

Avoid funds with sales loads and hidden fees

Sales loads, redemption fees, and other hidden charges reduce your capital and returns. Look for no-load funds or funds that explicitly disclose all costs. Many platforms now highlight these low-cost options, making them easier to identify.

Compare expense ratios across similar funds

Use fund screeners and calculators to evaluate expense ratios within the same category. For example, compare multiple S&P 500 index funds to find the one with the lowest cost while offering similar performance. Tools provided by investment platforms like Saxo streamline this process.

Pay attention to fund size and scale

Larger funds often benefit from economies of scale, allowing them to charge lower expense ratios. These savings come from spreading operational costs across a greater pool of assets. While smaller funds may promise higher returns, they often carry higher costs due to their limited asset base.

Assess the trade-off between cost and performance

Evaluate whether a fund's expense ratio aligns with its potential to deliver returns. A higher-cost, actively managed fund may justify its expense if it consistently outperforms low-cost alternatives. However, only a small fraction of actively managed funds achieve this over the long term, so proceed cautiously.

Conclusion: Expense ratios shouldn't be overlooked

At first, expense ratios might not seem like a big deal, but over time, these small percentages can quietly eat away at your returns, so understanding and managing them is important.

Choosing funds with low expense ratios—like index funds and ETFs—keeps more of your money invested and growing. Thanks to compounding, even a tiny difference in costs can add up over decades. That's why comparing funds, avoiding extra fees, and sticking with tax-efficient options are so important.

Remember that the less you pay in fees, the more you keep in your pocket. Taking the time to evaluate expense ratios now may significantly impact your long-term financial success.