An Introduction to Index Investing Costs – ETF Fees & Expense Ratios

Focus on Investing costs and ETF fees

In this article, we will look at how you can increase your return on investments by cutting costs and why ETF Expense Ratios are crucial to your returns. There are two types costs when buying an ETF:

  • ETF Expense Ratio (similarly to any Fund, the Asset Manager charges an annual fee for managing the assets)
  • Brokerage costs – how much will your broker charge when you buy and sell the ETF. These costs also add up if you invest on a recurrent basis and when you rebalance your portfolio

Why Cost Matters

Cutting costs is an essential part of every investor’s success strategy.  When it comes to investing, every dollar that is paid as trading commissions or management fees is a dollar lost. The main point here is that these costs can be controlled and thus minimized.

While Brokerage costs are one off (when you buy/sell), ETF Expense ratio is charged annually.

Bankeronwheels.com has a ETF Fee calculator where you can plug ETF Expense Ratios for 2 Funds and compare how much you will lose out over the life of an investment – an illustration of how it works is shown below with a starting investment of $100k

After 25 years the difference is a staggering $92.7k between a Fund with 0.05% Fee and a Fund with 0.5% Fee (do your own simulation)

bankeronwheels fee calculator for etfs index investing
Figure 1: The long-term impact of investment costs on portfolio balances. Source: Bankeronwheels.com ETF Fee Calculator - click on the image to open the calculator

Improving Returns by Reducing Costs

There are two methods of improving after-cost returns for investors – earning higher returns by using a winning investment strategy or getting a winning manager, and the other method is by reducing expenses. You have limited control over the first one since you don’t that in advance. You can fully control the second factor.

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Figure 2: The impact of costs on overall investor returns

Use Indexing to Cut Costs

ETFs (exchange-traded funds) and index funds usually have the lowest costs in the mutual funds industry. Therefore, by using indexed investment strategies, you can easily outperform higher-cost active managers.

Below are fees typically charged by Vanguard which is one of the cheapest Asset Managers in the industry (Google “Bogleheads” to understand why Vanguard has such a large fan base). Along with BlackRock and State Street, these are the TOP 3 ETF providers and here is how their funds compare considering only the Expense Ratios:

bloomberg comparison of etf fees blackrock vanguard state street
Figure 3. Vanguard is known for being the cheapest ETF Provider

Think Twice before paying more than 0.4% annually

As you can see, most funds charge fees below 0.4%. Specialized ETFs can be more expensive and that’s why it’s good to have a strong reason to buy them.

Expense Ratios can depend on the type of underlying assets e.g.:

  • Blue Chip Stock ETFs should have the lowest charges. E.g. S&P 500 ETF from Vanguard VOO charges only 0.03% annually
  • Bond ETFs have slightly higher charges but some of the main Bond ETFs called Aggregate Funds (and probably the only ones you would need for a simple Investment Strategy whether it’s a 1 Year or 5 Year horizon) don’t charge more than 0.05%
Remember, there are also other things to consider in choosing an ETF especially for Bonds that are a bit more complex than Stocks as you can read in our  Bond ETF Guide
 
aggregate core bond ETF agg bnd biv schz near blackrock ishares vanguard expense ratios etf fees
Figure 4. Bond ETF Expense Ratios can be below 0.05% as well

Using Tax- Management Strategies to Improve After-Tax Returns

Reducing tax liability is another method of increasing returns. This can be done by allocating investments strategically among tax-advantaged and taxable accounts. The primary aim of this investment strategy is to hold tax-efficient investments like ETFs or broad-market stock index funds in taxable accounts while maintaining tax-inefficient investments like taxable bonds in retirement accounts.

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Difference between ETFs and Index Funds

Remember there are differences between Index (Mutual) Funds and ETFs – while both are cheap on an annual basis ETFs give you flexbility since you can trade them at any time like regular Stocks while Index Funds don’t have any commission fees but give you less flexibility. If you’re in for the long term and contribute every month commission fees can quickly add up as well hence you may consider Index Mutual Funds.

 

ETF Fees vs. Index Funds Fees - Comparison

difference index mutual funds and etfs comparison - fees and commissions
Figure 5 - Comparison of Index Fund and ETF Fees

Conclusion

Although, as an investor, you cannot control the market, you can control what you pay to invest. 

Over time employing cost-reduction investment strategies will lead to bigger returns and when compounded over an extended period of time, the earnings will be significant

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Adam
Adam
15 days ago

Your calculator is really nice and illustrates the massive impact. Most people tend to underestimate it.