Carefully Considering Ownership Costs

Costs matter. Whether you’re buying a car or selecting investments for your portfolio, the costs you expect to pay are likely an important factor in making a financial decision.

People rely on different sources of information to make informed decisions. When buying a car, for example, the sticker price indicates about how much you may expect to pay for a car. But the costs of car ownership do not end there. Taxes, insurance, fuel, routine maintenance, and unexpected repairs (and where repairs are made) must be considered for complete ownership costs. While some costs are easily observable, other equally important ownership costs are obscure. Similarly, when selecting investment vehicles for constructing a portfolio both explicit and implicit costs must be considered to properly evaluate how cost‑effective a wealth planning strategy may be.


Mutual funds are the simplest way to illustrate this. Like all investments, mutual funds have differing management costs, all of which impact net investor return. The most easily observable measure of cost to identify is the expense ratio, which must be disclosed. Like a car’s sticker price, expense ratios tells you much about what you can expect to pay for different mutual and exchange traded funds. For investors looking to save on costs, expense ratios influence many decisions.

Exhibit 1 illustrates the “outperformance rate” for the proportion of surviving active equity mutual funds beating their relative category index over a 15-year period. To clarify the link between expense ratio and performance, outperformance rates are shown by quartiles and sorted by their expense ratios. The chart shows that the outperformance rate of active funds has not only lagged but been inversely related to expense ratio. Just 6% of active funds in the highest expense ratio quartile beat their index, compared to 25% for the lowest expense ratio quartile.

Exhibit 1. High Costs Can Reduce Performance, Equity Fund Winners and Losers Based on Expense Ratios (%)

The sample includes funds at the beginning of the 15-year period ending December 31, 2017. Funds are sorted into quartiles within their category based on average expense ratio over the sample period. The chart shows the percentage of winner and loser funds by expense ratio quartile; winners are funds that survived and outperformed their respective Morningstar category benchmark, and losers are funds that either did not survive or did not outperform their respective Morningstar category benchmark. US-domiciled open-end mutual fund data is from Morningstar and Center for Research in Security Prices (CRSP) from the University of Chicago. Equity fund sample includes the Morningstar historical categories: Diversified Emerging Markets, Europe Stock, Foreign Large Blend, Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Blend, Foreign Small/Mid Growth, Foreign Small/Mid Value, Japan Stock, Large Blend, Large Growth, Large Value, Mid-Cap Blend, Mid-Cap Value, Miscellaneous Region, Pacific/Asia ex-Japan Stock, Small Blend, Small Growth, Small Value, and World Stock. For additional information regarding the Morningstar historical categories, please see “The Morningstar Category Classifications.”

Index funds and fund-of-funds are excluded from the sample. The return, expense ratio, and turnover for funds with multiple share classes are taken as the asset-weighted average of the individual share class observations. For additional methodology, please refer to Dimensional Fund Advisors’ brochure, Mutual Fund Landscape 2018. Past performance is no guarantee of future results.

Dead weight from high expense ratios presents a challenging hurdle for many active equity funds to overcome. From the investor’s viewpoint, selecting among funds with similar asset allocations having a low expense ratio of 0.25% vs. those about 1.25% potentially could mean savings of $10,000 per year on every $1 million invested. As Exhibit 2 illustrates, that difference can add up over time. However, at least some investment managers of higher-cost funds may be able to enhance performance sufficiently to offset their high costs.

Exhibit 2. Hypothetical Growth of $1 Million at 6%, Less Expenses

For illustrative purposes only and not representative of an actual investment. This hypothetical illustration is intended to show the potential impact of higher expense ratios and does not represent any investor’s actual experience. Assumes a starting account balance of $1 million and a 6% compound annual growth rate less expense ratios of 0.25%, 0.75%, and 1.25% applied over a 15-year time horizon. Performance of a hypothetical investment does not reflect transaction costs, taxes, other potential costs, or returns that any investor would have actually attained and may not reflect the true costs, including management fees of an actual portfolio. Actual results may vary significantly. Changing the assumptions would result in different outcomes. For example, the savings and difference between the ending account balances would be lower if the starting investment amount were lower.


The poor track record of so many active mutual funds with high expense ratios has led many investors to select mutual funds based solely on expense ratio. That could be a mistake. As with a car’s sticker price, an expense ratio does not measure the complete cost of ownership. For example, index funds often rank near the bottom of their peers’ expense ratios. These funds are designed to track or match the components of arbitrary indexes formulated by commercial index providers, such as Russell or MSCI.

Important investment management decisions, such as which securities to include or exclude, are not within an index fund manager’s discretion and effectively outsourced to the index provider. Additionally, the prescribed reconstitution schedule for an index, when certain stocks are added or deleted to that index, may force index fund managers to buy stocks when demand is high and sell stocks when demand is low, increasing costs. Price-insensitive buying and selling is required for an index fund to “stay true” to the underlying index mandate. Diminished overall returns can result from sub-optimal transactions: for a given amount of trading (or turnover), the cost per unit due to a strictly regimented trading tends to be higher. These indirect costs are unpublished.

Further, because indices of commercial providers are reconstituted only infrequently (typically once per year), index funds that track them buy and sell underlying holdings based on stale eligibility criteria. For example, the characteristics of a particular “value” stock1 may have changed since the last reconstitution date, but those changes would not affect that stock’s inclusion in its commercial value index. Incoming cash flows into a value index fund, say, may continue to purchase securities that could be more like growth stocks2 (and vice versa). To avoid being different than the index they mimic, index managers invest using a rear-view mirror rather than watching the road ahead.

For active stock picking approaches, both the total amount of trading and the cost per trade usually will be higher than with indexing strategies. If an active manager trades excessively or inefficiently, commissions and price impact from increased trading will progressively eat away at returns. Using our car analogy, this is like incessantly jamming on the brakes or accelerating quickly. Subjecting any car to such abusive treatment results in added wear and tear and greater fuel consumption, increasing the total cost of ownership over time. Moreover, for investors holding funds in taxable accounts, excessive trading increases cost of ownership by realizing income subject to tax sooner.

Unnecessary turnover and higher costs per trade can be avoided, such as with portfolio strategies managed by Dimensional Fund Advisors. In contrast to both highly regimented index and high-turnover active strategies, a flexible management approach reduces the costs of immediacy, and thus enables opportunistic execution. Reducing implicit costs adds value. Keeping turnover low, remaining flexible, and transacting only when the potential benefits of a trade outweigh the costs, help keep overall trading costs even lower. This not only reduces complete total costs of ownership but also translates into higher portfolio returns.


Estimating the complete cost of owning any investment vehicle, like mutual funds, can be difficult to assess in advance. There are both implicit and explicit costs. Deciding requires a thorough understanding of costs beyond looking at expense ratio disclosures. Investors should think beyond any single cost metric and instead evaluate the total cost of ownership relative to the potential total benefit for total portfolio return based on a clear understanding of how a management methodology may reliably improve results.

Rather than focus too much time on evaluating investment costs, successful families should spend more time evaluating independent Certified Financial PlannerTM professionals with the right education and expertise that may help them take control of their financial future and make the truly informed decisions necessary to gain real peace of mind and enjoy a more abundant retirement.

1A stock trading at a low price relative to a measure of fundamental value, such as book value or earnings.

2 A stock trading at a high price relative to a measure of fundamental value, such as book value or earnings.