How ETF Fees Eat Away At Your Returns

If expense fees are ‘virtually free,’ why do they take a bite of your real return?

According to the ETF.com database, the average ETF fee has fallen to only 0.44 percent. One media outlet called these fees virtually free. Not only do I disagree, I’m not even sure they are declining.

I frame fees as a percentage of future expected real returns. That’s because I define money as “stored energy that gives us choices in life.” Unfortunately, we must pay for goods and services in inflation-adjusted dollars.

With stock market valuations looking relatively high, many feel real inflation returns will be more modest over the next decade. William Bernstein, author of the new book “Rational Expectations,” told me he sees stocks returning closer to a 3 percent annual real return, and a negative 1 percent real return on bonds. This equates to only a 1 percent annual real return for a portfolio comprising half stocks and half bonds.

Giving Back Returns

While no one can state with certainty what market returns will be over the next decade, clearly, high-quality bonds have little room for future capital appreciation from rate decreases. And possible increases in rates will result in the decline in bond ETF prices.

If such a portfolio only beats inflation by 1 percentage point annually, paying 0.44 percent is like giving up 44 percent of your real return. If this isn’t bad enough, the expense ratio is only part of the fees. ETFs have bid/ask spreads and can be bought at a premium and sold at a discount.

Finally, emotions are fees too. Over the last decade, Morningstar research demonstrated that the average investor earned a full 2.49 percentage points less annually than did the funds themselves. This investor gap may be less for ETFs than mutual funds, but likely exists with ETFs as well since performance chasing is a human instinct.

Thus, total fees of ETFs are far from free. In fact, you may be taking all of the risk and giving up all of your expected real turns.

What To Do?

The implications of the above are simple. First, keep fees dirt low. Don’t settle for average fees. Next, remember that broader is better.

Performance chasing is greater for narrower funds than for the broad total stock and total bond ETFs category. Fortunately, broader ETFs cost far less.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for CBS MoneyWatch.