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Little Things: Little Expenses Can Make Big Differences

Talk with a group of investors about mutual fund expenses and you'll often hear two schools of thought from them: When the market is roaring upward and funds are making them plenty of money, annual expenses don't seem to matter as much as when the opposite is true and the bears are in control.

But expenses are a very real part of fund investing and keeping your eye on them is always important no matter what's going on in the market.

Over the past few months, The Vanguard Group has been running print ads supporting the expenses-do-matter argument. Sure, the ads are self-serving as this Valley Forge, Penn. fund family has established itself as the fund industry's low-cost provider, but the lesson the ads teach is one all investors need to be mindful of.

Part of one such ad, titled "Controlling Expenses" reads: "While investing can never promise a sure thing, it does offer a few absolutes. One being that, if you have two funds and both perform identically, the fund with the lower expense ratio will ultimately return more than the other. "

To help new investors see what a dollar difference annual expenses can make on what ends up in your pocket, I asked Vanguard run a few hypotheticals.

Assuming an initial investment of $5000, and that you held on to that fund investment for five, 10 and 20 years, here's look at how a fund's annual expenses would impact a nest egg:

Bond Funds. According to Lipper, the average expense ratio on bond funds in 2002 was 1.10 percent. On Vanguard's bond funds it was 0.18 percent. Given an annual return of 6 percent, after expenses the average bond fund's annual return would be 4.85 percent and the return on the average Vanguard fund would be 5.81 percent.

After five years of investing, the difference in expense ratios meant a $296 difference in ending balances ( $6631 for the low expense ratio fund vs. $6335 for the higher one.) For the investor holding on for 10 years, the one who selected the fund with the lower expenses would have $8,795 in their coffer; those choosing the higher expensed fund, $8,026.

Where the numbers show the most significance, are for long-term investors---those holding on to their investment for 20 years. Ending balances in that case are thousands of dollars apart: $12,884 for the fund with the higher expense ratio and $15,469 for the fund with the lower expenses.

Stock Funds. Put $5000 into a typical stock fund with an annual expense ratio of 1.59 percent (again, last year's average), and an average annual return of 10 percent per year, and at the end of five years your account would have a balance of $7,442; after 10 years, $11,076; and after 20 years, $24,536.

Decide to go with a stock fund that has a very the low annual expense ratio of 0.33 percent and your ending balances would look like this: After 5 years, you'd have $7,921; after 10 years, $12,548; and after 20 years, $31,493.

The American Association of Individual Investors (AAII) tells its members that choosing a fund with an expense ratio that's significantly higher than the average means that "the long-term performance drag will be costly".

In the stock fund example used above, that long-term difference amounted to $6957---or, about a 28 percent difference in ending account balances.

The AAII also reminds investors that expense ratios on stock funds are higher than they are on bond funds; that international funds are more expensive than domestic ones; and, funds having plenty of assets are cheaper to run than small funds with fewer assets.

Keep in mind, while expense ratios can make a difference in how happy you are with your fund's return, don't select a fund based upon its annual expenses alone, Start your fund search by making sure that the fund type is right for your investing needs. Once that's been decided, then look at things like its performance, management and expenses.


Dian Vujovich is a nationally syndicated mutual fund columnist, author of a number of books including Straight Talk About Mutual Funds (McGraw-Hill), and publisher of this web site.

To read more articles, please visit the column archive.

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