Mutual Fund Expense Ratios: How High Is Too High?

Haas, Eric E.
September 2004
Journal of Financial Planning;Sep2004, Vol. 17 Issue 9, p54
Academic Journal
How high can a mutual fund expense ratio be before it eliminates the beneficial diversification impact the addition of the fund can bring to an investor's portfolio? This paper attempts to answer that question through the derivation of an equation. The study focuses on index mutual funds, but may apply to other types of funds as well, including actively managed funds such as small-cap stock and commodity futures funds. To measure whether the addition of a mutual fund actually improves the risk-adjusted performance of the portfolio, the Sharpe ratio is used as the starting point for the paper's solution. The equation then incorporates the maximum differential return (similar to a fund's tracking error). Because studies have found that an index fund's differential return can be approximated by the fund's expense ratio, the fund's expense ratio can then be substituted for the differential return in the equation. This final equation shows the highest expense ratio an investor should be willing to tolerate for a prospective new fund. A fund with a higher value would have a lower expected risk-adjusted return than the original portfolio. This equation can also be used to determine whether it is worth the cost of paying a financial advisor to place the investor in a fund accessible only through advisors. The article uses several examples to illustrate the application of the equation.


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