Mutual Funds and Foregone Earnings

Foregone earnings are the earnings shareholders would have realized if the retained annual expenses continued earning income. The annual expenses retained by the mutual fund are insignificant relative to the losses generated by foregone earnings over a long time period (10-30 years).  A mutual fund cost calculator was used to estimate annual expenses and foregone earnings of a $10,000 investment placed in a fund that yielded 12% (net or adjusted), refer to the chart below.

From year 2 to 5 the foregone earnings rapidly overtake the annual expenses as the majority of the total costs associated with the expense ratio. The expense ratio is an unavoidable cost of doing business with a mutual fund. Nonetheless, the fund with a lower expense ratio will generate a higher return, all things being equal. This is a very important concept to understand when one is evaluating index mutual funds. 

Index Mutual Funds and Expense Ratios

Index mutual funds are portfolios that mirror an index. For example, the Vanguard Index Trust 500 Fund invests your money into the stocks that make-up the S&P 500 Index. These funds are not actively managed by a fund manager. Therefore, the expense ratio associated with these funds is much lower (~0.2%) than with actively managed funds (1.5-2.5%). 

Be aware of mutual fund companies that offer S&P 500 Index funds with a high expense ratio (>0.25%). It is not uncommon to find a mutual fund that has created an S&P 500 Index that has an expense ratio of 0.8% or higher.

Investors will realize a higher return by investing in the index fund that has the lowest expense ratio, refer to the table below.

The difference may not seem significant, but over the long-term it can add up to a tremendous amount of money. For example, assume an initial investment of $10,000 was placed into an S&P 500 Index fund managed by "Ultimate Funds" (expense ratio of 0.2%) and a second $10,000 was placed into an S&P 500 Index fund managed by "High Cost Funds" (expense ratio of 0.8%) 30 years ago. The Index returned 12.7% over the last 30 years. The results of the experiment are given below.

The seemingly small difference between the two fund companies added up to $56,285 over 30 years!

Do not invest into index mutual funds that maintain high expense ratios!

Every mutual fund company that offers an S&P 500 Index will realize the same actual return. The index fund that maintains the lowest expense ratio will provide the highest return, refer to the plot below.

The Vanguard mutual fund company has created the Vanguard 500 Trust Fund which is an S&P 500 Index fund. The expense ratio associated with this fund, 0.2%, is one of the lowest in the entire industry. Consider index fund expense ratios of 0.25% as a benchmark. Shop around and buy the index fund that maintains the lowest expense ratio. Remember, index funds generate lower returns relative to aggressive funds. Long-term investors should buy aggressive funds that yielded net returns of at least 18% over the last 18 years (net return = actual return - expense ratio).

Funds normally report net returns.

In summary, over the long-term, expense ratios will significantly reduce the potential return earned in an index mutual fund. If you are going to invest in an index fund, choose the fund company that offers the lowest expense ratio.