Impact of expense ratio

ETF theory
Discuss the impact of expense ratios on ETF performance, especially in long-term investments.

Hint

Answer

Expense ratios, the annual fees charged by ETFs, can significantly impact long-term investment returns. Even small differences in expense ratios can compound over time, leading to notable variations in total returns, especially in scenarios where overall market returns are moderate.

The expense ratio of an ETF is a measure of what it costs an investment company to operate the ETF. It's expressed as a percentage of the fund's average assets under management (AUM). This ratio typically includes management fees, administrative fees, operating costs, and other various expenses incurred by the fund.

The expense ratio is deducted from the ETF’s total assets, which reduces the fund's overall return. For instance, if an ETF has an annual return of 8% and an expense ratio of 0.5%, the net return to investors would be 7.5%. In long-term investments, even small differences in expense ratios can have a significant impact due to the power of compounding. Over years or decades, a higher expense ratio can erode a substantial portion of potential earnings.
For example, a 1% expense ratio may not seem like much in a single year, but over 20 or 30 years, it can result in a significant reduction in total investment growth. Investors, particularly those focused on long-term growth, often consider expense ratios as a key factor when selecting ETFs. Lower expense ratios are generally preferred for long-term investment strategies to maximize returns.