How does a fund's expense ratio affect long-term returns?

• A. Higher expense ratios reduce net returns over time due to drag on performance and compounding effects.
• B. Expense ratio has no impact on returns if the fund performs well.
• C. Expense ratio only affects taxes, not performance.
• D. Lower expense ratios guarantee higher returns.

Answer: (A)

The effect being tested is how ongoing costs eat into investors’ returns over time. The expense ratio is the annual fee charged by the fund, taken from the assets, so the investor’s net return is the fund’s gross return minus that fee. Because money that isn’t taken as fees stays invested, the net returns compound more slowly when costs are higher. Over long horizons, even small differences in the expense ratio can lead to a substantially lower final portfolio value.

Thus, higher expense ratios reduce net returns over time due to the drag on performance and the compounding effects. Even if a fund performs well, the fee still reduces what you keep. Taxes and performance aren’t the same thing, and a lower expense ratio does not guarantee higher returns, though it improves the odds of keeping more of what the fund earns.