Definition: What is an expense ratio?
An expense ratio measures how much you’ll pay over the course of a year to own a fund. This money 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.
How expense ratios work
An expense ratio is the cost of owning a mutual fund or exchange-traded fund (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
However, there’s good news for investors, too: Expense ratios have been declining for years. 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.
What’s a good expense ratio?
To determine how good an expense ratio is, measure it against the simple average if you want to see how it ranks overall top to bottom, but also measure it against the asset-weighted average to see what many investors are paying for their funds. 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 0.50 percent in 2020 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 2020, the figure was 1.16 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 (0.18 percent) in 2020 is lower than the simple average (0.47), 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 funds, which are passively managed, fell from 0.27 percent in 2000 to just 0.06 percent in 2020. 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. Yes, you can find funds that charge zero fees.
How do expense ratios affect returns?
Expense ratios directly reduce your portfolio’s rate of return. There are two things that must be considered: 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.
Suddenly, our 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 index funds because they are used to pay fund managers, among other expenses. But for the individual investor, that is 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 = Total fund expenses/total assets under management
Because the numerator of the expense ratio is total fund expenses, it’s easy to see why actively managed funds come with higher expense ratios than index funds. After all, index funds are passively managed funds tied to the performance of an index, such as the S&P 500. Actively managed funds, on the other hand, must pay fund managers and analysts who research potential investments.
Other costs included in a fund’s expense ratio are taxes, legal fees, accounting and auditing, and recordkeeping. The buying and selling of securities are not included in a fund’s expense ratio. 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.
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. That’s a stunning amount, which you can minimize.
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.