Low Returns? Costs Matter

In a world of low returns, costs matter more than ever

When making big purchases, most of us are sensitive to price. An investor’s portfolio is, in a sense, often one of their biggest purchases, but many investors are more focused on returns than on examining their costs. And in a low-return environment, costs can play an especially crucial role in optimizing your portfolio’s performance.

While the market made some impressive gains earlier in the decade, many experts believe that times have likely changed, and those kinds of returns may not be attainable in the next few years. In a landscape where impressive returns may be few and far between, investors should consider taking a hard look at the costs of their investments.

While individual stocks tend to be the cheapest investment to own (after you pay the trading commission), it's hard to pick winners and sufficiently spread risk. That's why most investors turn to diversified assets like mutual funds and ETFs for their longer-term holdings. For example, the average expense ratio for an iShares ETF is 0.38%, while for the average mutual fund it is 1.03%.1

Fees take a toll

These numbers may sound small, but fees can really chip away at your total performance, especially in a low-return environment. For example, if the expected return is, say, 3%, a 1% expense ratio grabs nearly a third of earnings! And that makes a big difference over time as the impact of higher costs compound.

Of course, if higher-expense funds perform better, this might be worth it. However, the reality is that most active managers do not beat their benchmarks (85% have failed to do so in the past five years2, in fact), partly because their returns have been eroded by the higher prices.

It's important to note that ETFs, like mutual funds, come in a wide range of objectives to enable diversification and opportunity capture in any return environment – so you can invest in whatever you believe in, whether you coose a mutual fund or an ETF. Many ETFs have delivered solid performance by sticking to an index strategy and keeping costs low. iShares Core ETFs, for example, have outperformed over 80% of their mutual fund peers over the last five years when considering at post-tax returns3.

Watch out for taxes

And the post-tax number is important because mutual funds can also be costly come April 15. Outside of your tax-qualified accounts like 401k and IRA, investors may find themselves cutting Uncle Sam a check for capital gains taxes on funds that they hold – even if they didn't sell anything, and regardless of whether the funds have gone up or down in value– because of how the funds are structured. Both ETFs and mutual funds can result in capital gains taxes for investors, but the size of the tax bill often differs.

Actively managed mutual funds trade their holdings relatively frequently, since they typically seek to outperform the broader market. And the buying and selling activity of other investors can trigger capital gains for all fund holders, as the fund buys and sells securities to create and redeem shares to meet demand from investors. Over the last 10 years, the average annual tax cost for a mutual fund was 1.2%4.

ETFs have historically been more tax efficient than mutual funds. Because ETFs usually track an index, there is relatively little turnover among the portfolio holdings. And with most ETFs, unlike mutual funds, investors sell their shares on the open market – so the actions of other investors typically won't create undesired capital gains for you. (Of course, ETF shareholders can incur tax consequences when they sell shares on the exchange.)

Some fund providers are particularly focused on tax efficiency. On average, 97% of iShares ETFs have not paid a capital gains distribution on average over the last five years, compared to only 85% of Vanguard's ETFs and 80% of State Street's5.

Over time, fees and taxes can really eat into your overall returns – and, of course, the effect is more extreme the longer you hold your investment. If you kept $250,000 invested 10 years in the average mutual fund (expense ratio of 1.03%) and the average iShares ETF (expense ratio of 0.38%), the iShares account would end up with $56,000 more1.

Those seemingly small percentages add up over time – especially when returns are sparse. You can’t control the markets, but you owe it to yourself–and your investments – to consider costs, no matter the market conditions.

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