When it comes to investing in mutual funds or exchange-traded funds (ETFs), one of the most important factors to consider and understand is the expense ratio. An expense ratio measures how much you’ll pay over the course of a year to own a fund. A high expense ratio can significantly impact your returns, and it pays for things like the management of the fund, marketing, advertising and any 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’re referring to the expense ratio. Here’s how expense ratios work and what makes a good expense ratio.

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 percent of your investment in the fund. For example, a fund may charge 0.30 percent. That means you’ll pay $30 per year for every $10,000 you have invested in that fund.

You’ll pay this on an annual basis if you own the fund for the year. Don’t assume you can sell your fund just shy of a year and avoid the cost, however. For an ETF,  the management company will take the cost out of the fund’s net asset value daily behind the scenes, so it will be virtually invisible to you.

Why it’s important to understand expense ratios

Buyers of mutual funds and ETFs need to know what they’re paying for the funds. A fund with a high expense ratio could cost you 10 times – maybe more – what you might otherwise pay.

Typically, any expense ratio higher than one percent is high and should be avoided. Over an investing career, a low expense ratio could easily save you tens of thousands of dollars, if not more. And that’s real money for you and your retirement. However, it’s important to note that many investors choose to invest in funds with high expense ratios if it’s worth it for them in the long run.

Here’s some good news for investors: Expense ratios have been declining for years. Many passive funds out there have expense ratios below 0.10 percent, or $10 annually for every $10,000 invested, while a few have expense ratios of 0 percent, which is great for investors.

What’s 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 if you want to see how it ranks overall top to bottom.
  • Measure it against the asset-weighted average of all funds to see whether you’re getting a better price than most other investors.

Ultimately, search for a fund that falls below the asset-weighted average. As far as costs go, the lower, the better.

The answer to whether an expense ratio is a good one largely depends on what else is available across the industry. So let’s take a quick look at what’s been happening.

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. You can see the figures for both mutual funds and ETFs in the chart below.

There are three key things to note about this graphic.

  • Average expense ratios have declined considerably over the past 20 years, whether it’s a stock mutual fund or stock ETF. The fees on stock mutual funds have declined from 0.99 percent in 2000 to 0.44 percent in 2022 on an asset-weighted basis. An asset-weighted basis factors how much is in each fund and weights larger funds more heavily in the calculation.
  • The unweighted average is actually much higher than this, however. In 2022, the figure was 1.12 percent. If you threw a dart at a wall of mutual funds repeatedly, you’d average about this much. So this is a better measure of the average you’d find if you’re looking randomly.
  • The expense ratios on index stock ETFs typically start at a lower level and have also fallen over the last two decades. Similarly, the asset-weighted average (0.16 percent) in 2022 is lower than the simple average (0.46 percent), indicating that a lot of money is in cheaper funds.

It’s also worth noting that while mutual funds overall had higher expense ratios, a subset of them – stock index funds – had markedly lower fees, as seen below.

The asset-weighted average on stock index mutual funds, which are passively managed, fell from 0.27 percent in 2000 to just 0.05 percent in 2022. These funds are popular options in employer-sponsored 401(k) plans, and they’re cost-competitive 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 America’s top companies. These funds regularly charge less than 0.10 percent and range all the way to free. You can find funds that charge zero fees here.

How do expense ratios affect returns?

Expense ratios directly reduce your portfolio’s rate of return. Investors have 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 amplify your investment returns over the years. However, compounding also applies to fees because they are charged as a percentage of your position in that fund.

When charged as a percentage, fees eat up a larger and larger amount of money as your portfolio balance grows. Imagine you have been investing for many years and now, your $10,000 portfolio has grown to $1 million. However, instead of paying a 0.30 percent fee, you are paying a 1 percent fee every year. That means your annual fee is $10,000 – the entire balance of your original portfolio. And that’s a recurring fee, year after year.

And that $10,000 fee is not just the money today, but the greater amount it could compound into in 10 or 20 years or more. And again, you’re being assessed this fee every single year.

Suddenly, those fees don’t sound so reasonable. And yet, it is not uncommon for certain mutual funds to charge fees in this range. Mutual funds often come with higher fees than ETFs because they are used to pay fund managers, among other expenses. But for the individual investor, that fee can compound into a large amount of money.

Compare the above to an index fund with a 0.03 percent fee, which would result in a charge of $300 on your $1 million portfolio. Indeed, fees can greatly affect returns, so it’s important not to ignore them.

How is an expense ratio calculated?

Expense ratio (percentage) = Total fees charged annually/your total investment

Your fees are directly related to the expenses of the fund itself, and actively managed funds come with higher expense ratios than index funds because of the team of portfolio managers needed to operate the fund. Index funds are passively managed funds tied to 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, auditing and recordkeeping. While operating expenses can vary for mutual funds, the expense ratio tends to be relatively stable. The largest mutual funds have expense ratios that often remain the same from one year to next, even if the long-term trend has been downward.

What else you should consider about expense ratios

Experts recommend finding low-cost funds so you don’t lose big bucks to fees over the course of a career. And it’s not just the direct fees; you’re also losing the compounding value of those funds. Here’s how to calculate how much those fees cost you over time.

For example, if you made a one-time investment of $10,000 in a fund with a 1 percent expense ratio and earned the market’s average return of 10 percent annually over 20 years, it would cost you a total of $12,250 in fees. That’s a stunning amount, but you can minimize it.

Larger funds can often charge a lower expense ratio because they can spread out some costs, such as the management of the fund, across a wider base of assets. In contrast, a smaller fund may have to charge more to break even but may reduce its expense ratio to a competitive level as it grows.

Mutual funds may charge a sales load, sometimes a very pricey one of several percent, but that’s not included as part of the expense ratio. That’s an entirely different kind of fee, and you should do everything you can to avoid funds charging such fees. Major brokers offer tons of mutual funds without a sales load and with 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’re going to be relatively cheap, compared to the average mutual fund.
  • However, index mutual funds are also passively managed, and on the whole, they’re even cheaper than ETFs, but mutual funds come with disadvantages relative to ETFs.
  • Funds based on a major index such as the S&P 500 have among the lowest expense ratios.

Putting those data points together, good places to begin include S&P 500 index funds as either an ETF or mutual fund, though an ETF is likely the better option.

If you don’t mind doing a little legwork, some of the best brokers for ETF investing offer screeners that let you screen the fund world for high-performing low-cost funds. You simply pick the features that you’re looking for, and the screener narrows the field to the top picks. For example, Charles Schwab and Fidelity Investments both offer strong ways to sift through funds.

And Bankrate has identified some top low-cost ETFs for major segments of the market.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.