When it comes to investing in mutual funds or exchange-traded funds (ETFs), the expense ratio is one of the most important factors to consider and understand. An expense ratio measures how much you pay to own a fund over the course of a year. A high expense ratio can have a significant impact on your returns, and it pays for things like fund management, marketing, advertising and all other costs associated with running the fund. Both mutual funds and ETFs charge an expense ratio.
When someone discusses how expensive a fund is, they are referring to the expense ratio. Here’s how expense ratios work and what a good expense ratio is.
How expense ratios work
An expense ratio is the cost of owning a mutual fund or ETF. Think of the expense ratio as the management fee paid to the fund company for the benefit of owning the fund.
The expense ratio is measured as a percentage of your investment in the fund. For example, a fund may charge 0.30 percent. That means you pay $30 per year for every $10,000 you invested in that fund.
You pay this on an annual basis if you own the fund for that year. However, don’t assume you can sell your fund within a year and avoid the fees. With an ETF, the management company removes costs from the net asset value of the fund behind the scenes every day, so that they are virtually invisible to you.
Why it’s important to understand expense ratios
Buyers of mutual funds and ETFs need to know what they are paying for the funds. A fund with a high expense ratio could cost you ten times (maybe more) what you would otherwise pay.
Normally, any expense ratio higher than one percent is high and should be avoided. Over your investing career, a low expense ratio can easily save you tens of thousands of dollars, if not more. And that is real money for you and your pension. However, it is important to note that many investors choose to invest in funds with high expense ratios if it is worth it to them in the long run.
Here’s some good news for investors: Expense ratios have been falling for years. Many passive funds out there have an expense ratio of less than 0.10 percent, or $10 per year for every $10,000 invested, while a few have an expense ratio of 0 percent, which is great for investors.
What is a good expense ratio?
To determine how good an expense ratio is, you can measure it in two ways:
- Measure it against the simple average of all funds to see how it ranks overall from top to bottom.
- Measure it against the asset-weighted average of all funds to see if you’re getting a better price than most other investors.
Ultimately, look for a fund that falls below the asset-weighted average. As for costs, the lower the better.
The answer to whether an expense ratio is good largely depends on what else is available in the industry. So let’s take a quick look at what happened.
Expense ratios have been falling for years as cheaper passive ETFs have claimed more assets, forcing traditionally more expensive mutual funds to lower their expense ratios. The graph below shows the figures for both mutual funds and ETFs.
There are three important things you need to know about this image.
- Average expense ratios have fallen significantly over the past twenty years, whether it’s a stock mutual fund or a stock ETF. Fees for equity funds have fallen on an asset-weighted basis from 0.99 percent in 2000 to 0.44 percent in 2023. On an asset-weighted basis, how much is in each fund is determined and larger funds are weighted more heavily in the calculation.
- However, the unweighted average is much higher. In 2023 this was 1.12 percent. If you were to repeatedly throw a dart at a wall of mutual funds, you would average about this amount. So this is a better measure of the average you would find if you searched randomly.
- Expense ratios on index stock ETFs typically start at a lower level and have also fallen over the past two decades. Similarly, the asset-weighted average (0.16 percent) in 2023 is lower than the simple average (0.46 percent), suggesting a lot of money is in cheaper funds.
It’s also worth noting that while mutual funds generally had higher expense ratios, a subset of them – stock index funds – had significantly lower expenses, as seen below.
The asset-weighted average of stock index mutual funds, which are passively managed, fell from 0.27 percent in 2000 to just 0.05 percent in 2023. These funds are popular options in employer-sponsored 401(k) plans, and they are cost-effective. compete with passively managed ETFs.
Some of the cheapest funds are index funds based on the Standard & Poor’s 500 index, a collection of hundreds of top U.S. companies. These funds regularly charge less than 0.10 percent and range all the way to free. Here you will find funds that do not charge any fees.
How do expense ratios affect returns?
Expense ratios directly reduce the return of your portfolio. Investors need to consider two things here: the impact of high fees and the impact of compounding. Investing advocates often talk about the power of compounding to boost your investment returns over the years. However, compounding also applies to fees, as they are charged as a percentage of your position in that fund.
If fees are calculated as a percentage, the fees will take up an increasing amount of money as your wallet balance grows. Imagine that you have been investing for many years and now your portfolio has grown from €10,000 to €1 million. However, instead of a 0.30 percent fee, you pay a 1 percent fee every year. That means your annual fee is $10,000 – the entire balance of your original portfolio. And that is a recurring fee, year after year.
And that $10,000 fee is not just today’s money, but the larger amount it could generate 10 or 20 years or more from now. And again, you are assessed on this fee every year.
Suddenly those fees don’t sound so reasonable. And yet it is not unusual for certain mutual funds to charge fees in this range. Investment funds often have higher costs than ETFs, because they are used, among other things, to pay fund managers. But for the individual investor, that compensation can amount to a large amount of money.
Compare the above to an index fund with a 0.03 percent fee, which would result in a $300 charge on your $1 million portfolio. Costs can have a big impact on returns, so it’s important not to ignore them.
How is an expense ratio calculated?
Expense ratio (percentage) = Total annual costs/your total investment
Your fees are directly related to the costs of the fund itself, and actively managed funds have higher expense ratios than index funds because of the team of portfolio managers required to operate the fund. Index funds are passively managed funds that rely on the performance of an index, such as the S&P 500.
Other costs included in a fund’s expense ratio are taxes, legal fees, accounting, audits and administration. Although operating expenses for mutual funds can vary, the expense ratio is usually relatively stable. The largest mutual funds have expense ratios that often remain the same from year to year, even though the long-term trend is downward.
What else you need to think about about expense ratios
Experts recommend finding cheap funds so that you don’t lose a lot of money on fees over the course of your career. And it’s not just the direct fees; you also lose the compounding value of those funds. Here’s how to calculate how much these costs will cost you over time.
For example, if you make a one-time investment of $10,000 in a fund with a 1 percent expense ratio and earn the average market return of 10 percent per year over 20 years, it will cost you a total of $12,250 in fees. That’s a staggering amount, but you can minimize it.
Larger funds can often charge a lower expense ratio because they can spread some costs, such as fund management, over a broader asset base. In contrast, a smaller fund may need to charge more to break even, but can reduce its expense ratio to a competitive level as it grows.
Investment funds may charge a sales charge, sometimes very expensive, of several percent, but that is not included in the expense ratio. That’s a completely different type of fee, and you should do everything you can to prevent funds from charging such fees. Major brokers offer tons of mutual funds with no sales charges and very low expense ratios.
How to find funds with low expense ratios
So high expense ratios can cost you a lot of money, but how do you find funds with low expense ratios? You have options, but it’s important to know a few things:
- Almost all ETFs are passively managed index funds, meaning they aim to track the performance of a specific index, so they will be relatively cheap compared to the average mutual fund.
- However, index mutual funds are also passively managed and are even cheaper overall than ETFs, but mutual funds have disadvantages compared to ETFs.
- Funds based on a major index such as the S&P 500 have among the lowest expense ratios.
Putting these data points together, S&P 500 index funds as an ETF or mutual fund are a good place to start, although an ETF is probably the better option.
If you don’t mind doing a little legwork, some of the best brokers for ETF investing offer screeners to help you screen the fund world for high-performing, low-cost funds. You simply choose the features you’re looking for, and the screener narrows the field to the top choices. For example, Charles Schwab and Fidelity Investments both offer strong ways to search funds.
And Bankrate has identified a number of low-cost ETFs for large market segments.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
