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Mutual Fund Expense Ratio

Fund expenses come directly from your pocket, since they are money, which you could have taken. It is true that they are the needed "evil", but do you really know how much is exactly your cost for maintaining a particular fund?

It is true that a monthly or annual fee gets you rid of the headache of having to constantly monitor and beat the market. But do not fall in the common illusion that high fees mean high performance of the fund manager and better results on the market. Moreover, this betting on a particular fund manager's abilities may eventually lead to lagging index, from which your portfolio may seriously suffer.

Both fees and tax efficiency represent one of the most important factors that investors should take under consideration when selecting a fund in which they want to invest. Despite this, many investors neglect this advice and only look at the performance of the target fund, neglecting that fees and taxes represent a definite expense, whereas returns vary over the time.

As mentioned above, the expense ratio occupies the first place of importance together with tax implications, when we speak about diversified portfolios. This fact is worth repeating since many investors neglect the significance of these variables.

A bull market, in which confidence and optimism prevails, can temporarily justify the high fees, since they will be compensated by the high returns on the investment. But this bull market cannot last forever and can be followed by a bear market, in which prices fall. In such situations and in the cases of normal returns, fee levels can have a substantial effect.

The payment of high expenses has a negative impact on the fund performance even in years when the returns are substantially high. This points to the logical conclusion that the way returns accumulate with time, the same happens with expenses, which may lead a lag in the fund performance.

In order to better feel the difference between the expenses incurred by index fund and a typical managed fund, consider the following example:

You have decided to invest $100 000 in an index fund that charges 0.20% for expenses. On the other hand, one of your friends has decided to invest the same amount in a typical managed fund. It charges him 1.2% annually. We assume that both funds have the same 9% annual gross (before expenses). As a result in 20 years the ending balance of your low-cost index fund will be $538,920 while your friend's ending balance will be $442,967. As a result of his higher expense fund investment he would have paid $95,954 in turns of expenses.

It is obvious that you have made the right choice by investing in an index fund. By indexing you will incur less cost and will benefit from the tax efficiency. But never forget that index funds have their hidden traps such as the charge of managed-fund prices.

Furthermore, many financial advisors point out that index funds provide less degree of diversification. This is not true, since there are different types of indexes (international, small-cap) which facilitate diversification and at the same time reduce expenses.

Beware of the expense ratio whenever you consider the investing of your cash! Never forget to put it in your list of criteria together with the tax implications of the particular opportunity!

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