I’m going over the dozen articles I am scheduling for publication at About.com, a division of The New York Times during the month of October, starting with today’s newest feature What Is a Mutual Fund Sales Load?.  I came across something that was definitely worth pointing out to those of you who own mutual funds in your personal portfolio.

[mainbodyad]The summary: Expense ratios matter.  In fact, expense ratios matter a lot.

The long version: I was reading the documents for some of the private label mutual funds offered by UBS, which used to be the Union Bank of Switzerland.  For example, take the UBS U.S. Equity Alpha Fund which “Employs our 25+ year price-to-intrinsic value philosophy to identify what we believe are underpriced and overpriced securities.”  The fund has 113 positions, of which 79 are long and 34 are short.  Common stock long is 82.34% of the portfolio, common stock short is 16.05%, cash and cash equivalents are 0.91% and money market is 0.70%.

The 10 biggest holdings are:

  • Exxon Mobil Corp. – 4.12%
  • Comcast Corp – 3.19%
  • Apple Inc. – 3.18%
  • Microsoft Corp. – 3.12%
  • PepsiCo Inc. – 3.09%
  • Procter & Gamble Co. – 3.08%
  • JPMorgan Chase & Co. – 3.05%
  • Wells Fargo & Co. – 3.03%
  • AT&T Inc. – 2.52%
  • Exelon Corp. – 2.38%

But the thing that caught my attention: The Class A mutual fund shares carry a net expense ratio of 2.26%.  I cannot even remotely think of how an expense ratio that high for these holdings could be justified for what amounts to a predominately domestic equity fund.

Mutual Fund Expense Ratios

I cannot think of a reason any rational investor would agree to pay an expense ratio as high as 2.26% for what amounts to the equivalent of a domestic equity fund when you can buy a low cost index fund with an expense ratio as low as 0.18%. It defies common sense.

Compare That to the Expense Ratio of a Low-Cost Index Fund

The Vanguard 500 Index Investor (Ticker Symbol VFINX) is one of the biggest low-cost index funds in the world and is designed to track the S&P 500.  It has an expense ratio of 0.18%.  Take a look at the top 10 holdings held by this fund:

  • Exxon Mobile Corp. – 3.13%
  • Apple Inc. – 2.45%
  • Microsoft – 1.88%
  • Procter & Gamble – 1.85%
  • Johnson & Johnson – 1.75%
  • IBM – 1.70%
  • General Electric – 1.65%
  • JP Morgan Chase & Co. – 1.56%
  • Chevron – 1.55%
  • Bank of America – 1.54%

Notice anything?  Five out of the top ten holdings are the same as the ones held by the expensive private label fund! The UBS fund is literally 12.55 times more expensive and yet half of the top 10 holdings are the same!  That is insane.

The Effects of Mutual Fund Expense Ratios Over Time

To put it into perspective: If the two mutual funds both grew at 10% compounded – the exact same gross performance – the Vanguard fund would turn in results 2.08% higher than the UBS fund due to the lower expense ratio.  In other words, the net return for the UBS mutual fund holder would be 7.74% annually (10% – 2.26% = 7.74%) and the return for the Vanguard mutual fund holder would be 9.92% (10% – 0.18% = 9.92%).

Imagine you invested $10,000 per year starting from the time you were 22 years old until you retired at 65.  That is 43 years of compounding.

  • The low-cost index fund investor would have $6,223,936 before taxes
  • The expensive private label mutual fund investor would have $3,058,438 before taxes

The exact same amount invested each year.  The exact same gross return.  The exact same length of time for your money to grow.  More than twice as much money.  All because of the expense ratio of the mutual fund.

Sometimes, Expense Ratios Can Be Justified

[mainbodyad]A standard 2% and 20% arrangement for a hedge fund might be a bargain if the manager is good because they could utilize mortgages for real estate, business loans, issue private bonds and a host of other capital structure financial engineering that isn’t possible with a typical mutual fund.

Likewise, international mutual funds and mutual funds with managers who have stellar long-term returns could charge up to 1.25% and probably be worth it.  I’ve adored the stock selection process at Tweedy Browne & Company since I was a child and they have always charged 1.25% or so on money managed for clients and through the mutual funds under their stewardship.