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What’s the Maximum Expense Ratio Somebody Should Pay for a Mutual Fund?

A reader writes in, asking:

“As I try to select among the funds in my 401k plan, is there a limit to the high end of expense ratio that you suggest not going beyond?”

The maximum expense ratio that I would pay for a fund depends on the context. Specifically, it depends on the availability of a less expensive suitable substitute.

For example, consider an investor with a $100,000 portfolio, all of which is in her 401(k). She has decided that her ideal asset allocation would be:

  • 60% in US stocks,
  • 20% in international stocks, and
  • 20% in bonds.

And, in her 401(k), the lowest-cost investment options in each of those categories are:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

Our investor has a dilemma. She wants a 20% international stock allocation in her portfolio. But she would have to pay an extra 0.6% per year for that part of the portfolio in order to have such an allocation (rather than just allocating the entire stock part of the portfolio to the US stock index fund).

Frankly, if I were in that position, I wouldn’t pay the additional cost. I appreciate international diversification, but an avoidable cost of 0.6% per year is a high hurdle for the diversification to overcome in terms of added value.

But what if our investor’s lowest-cost investment options were as follows?

  • An actively managed US stock fund, with an expense ratio of 0.65%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, our hypothetical investor would now only be paying an additional 0.05% per year for her international allocation. The international fund’s cost hasn’t changed at all, but it has become quite a bit more attractive because the alternative (i.e., keeping the entire stock allocation in the US stock fund) has become more expensive.

Point being: The maximum expense ratio that it makes sense to pay depends on the cost and suitability of the nearest substitute. In our first scenario the 0.7% expense ratio was too high because there was a low-cost substitute (albeit an imperfect substitute). In the second scenario, the 0.7% expense ratio was not prohibitive, because there was no low-cost substitute.

What if There Are Multiple Accounts?

Let’s look at one more hypothetical scenario. Our investor still desires an allocation of 60% US stocks, 20% international stocks, and 20% bonds. And the options in her 401(k) are the same as in our first scenario above:

  • A “total stock market” index fund with an expense ratio of 0.1%,
  • An actively managed international stock fund with an expense ratio of 0.7%, and
  • A “total bond market” index fund with an expense ratio of 0.1%.

In this case, however, her portfolio consists of $50,000 in her 401(k) and $50,000 in a Vanguard IRA. In this case, she has no reason whatsoever to pay the high cost of the international fund in her 401(k), because she could achieve her desired overall allocation by buying an international index fund/ETF in her IRA.

Again, the overall conclusion is that the maximum “acceptable” expense ratio for a fund varies based on the availability of less expensive suitable substitutes.

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