TC1 – TC2
ER2 – ER1
TC1 and ER1 refer to transaction costs and the expense ratio, respectively, for Product 1.
TC2 and ER2 refer to transaction costs and the expense ratio, respectively, for Product 2.
How does one use the formula? For a quick tutorial, I can provide an example similar to Scenario 2 above. Let’s say Product 1 is a mutual fund and TC1 and ER1 equal 2 and 8 basis points (bps), respectively, while Product 2 is an ETF and TC2 and ER2 equal 1 and 20 bps, respectively.
The break-even holding period (in years) is:
2 – 1
20 – 8
This equals one-twelfth of a year, or roughly four weeks. In other words, the mutual fund costs more initially, but after four weeks, it costs less overall because of expense ratio savings. Thus, an investor expecting to hold this investment for more than four weeks may prefer the mutual fund to the ETF.
A more thorough review of selection considerations (and the math behind the formula) can be found in our paperChoosing between ETFs and mutual funds. Break-even analyses like this are not so different from the purchasing decisions we might make daily, where our expected time horizon can be an important factor, even when deciding between buying or renting furniture. When it comes to investing, making decisions with a time period in mind can help your clients save costs, and ultimately bring them closer to their investment goals.
I would like to thank my colleague David Kwon (the apartment hunter) for his contributions to this blog and our white paper.