Why You Should Pay Attention to the Expense Ratio on Mutual Funds and ETFs

Investing isn’t the easiest concept to wrap your head around. When you first get started with investing, there are several terms and concepts you may be learning.

One of these terms is the expense ratio.

Expense ratios may not seem like a big deal initially, but they play a huge factor in the returns you’ll earn from your investments. This is even truer as you continue investing over years or decades.

Here’s what you need to know about expense ratios and how much they impact your investments.

What Is an Expense Ratio?

The expense ratio is a representation of the costs a mutual fund or exchange-traded fund (ETF) incurs to operate the fund.

It is usually represented as a percentage of assets deducted from your investment each year.

Most investment price quotes list a fund’s expense ratio, so it’s relatively easy to find. You can also find a fund’s expense ratio in the fund’s prospectus.

Fees covered

Depending on the particular fund, the expense ratio may cover a range of different expenses. 

Running a mutual fund is like running a business.

These fees include things like research fees, equipment needed to run the fund, computers, travel expenses related to running the fund and other costs in the ordinary course of business.

Expense ratios can include fees such as:

  • General fund expenses
  • 12b-1 fees (marketing fees)
  • Management fees
  • Administrative fees
  • Operating costs

Some expenses aren’t included in the expense ratio.

These include fees like transaction fees, brokerage costs or initial or deferred sales charges.

Sometimes there can be gross expense ratios and net expense ratios. The net expense ratio is what is actually paid by an investor after accounting for fee waivers or reimbursements.

Why Do Expense Ratios Differ From Investment to Investment?

Just like individual businesses are run in different ways and have different expenses, mutual funds and ETFs have different expense ratios.

Actively-managed funds

In general, actively managed funds that try to provide outsized returns tend to charge higher expense ratios than index funds that are simply mimicking an index with the hopes of matching its returns. 

This makes sense.

Look:

Active funds have to pay managers that have to do extensive research and make judgment calls on what and when to buy and sell individual investments. 

Index funds

Index funds, on the other hand, only have to purchase similar securities as the index they’re mimicking. 

They don’t have to perform a ton of research or come up with unique methods to try to beat the market.

Instead, they’re focused on building a copycat of a model that is publicly available.

The Investment Company Institute (ICI) released a report in March 2019 detailing average expense ratios.

In 2018, the average equity mutual fund expense ratio was 0.55% and the average bond mutual fund expense ratio was 0.48%.

For actively managed equity mutual funds, the average expense ratio was 0.76% in 2018 while index equity mutual fund expense ratios averaged 0.08% in 2018.

How and When Are Expense Ratios Charged?

Expense ratios aren’t typically charged as a deduction from your investment.

You don’t have to redeem shares of your mutual fund to pay them and you won’t see it as a line item on your statement. 

Rather:

Most funds take the expense ratio fee from the income the fund generates over a year. This, in turn, lowers the income available to the owners of the fund which also reduces your returns. 

Of course, not all funds generate income from dividends or other sources.

That said, most funds hold cash at some point so they can buy and sell investments as needed. 

The expense ratio fees will be taken out of the cash holdings or, if there are no cash holdings, some investments within the fund may be sold to generate the cash to pay the expenses.

Why Expense Ratios Matter More Than You’d Think

While you probably wouldn’t drive across town to save one percent on the gas you put in your car, you should seriously consider trying to lower your expense ratios by one percent.

Expense ratios become a big deal when you invest over long time periods.

Why?

It all has to do with the power of compounding returns.

Essentially, compounding returns is the phenomenon of your investments’ returns in year 1 earning future returns in year 2 and so on. 

As the investment grows, the returns on your returns, or compounding returns, can eventually be more than your initial investment. 

When you lose some of these returns to an expense ratio, you give up some of your future compounding returns.

Now:

Some funds with higher expense ratios may be justified if they consistently outperform and continue to outperform other funds with lower expense ratios. 

Consistently outperforming is a rarity in the investment world. Additionally, higher returns are never guaranteed, but a lower expense ratio can be.

The impact of expense ratios on returns

Expense ratios could have a huge impact on your returns, especially when you hold an investment for decades.

Let’s take a look at a hypothetical example to see the impact expense ratios can have.

Below is a table of two hypothetical investments you could invest in. Both investments are exactly the same except for their expense ratios. 

They both have the same 8% annual returns before the expense ratio.

The difference:

  • Investment A charges a 1.25% expense ratio
  • Investment B charges a 0.25% expense ratio

For this example, you invest a lump sum of $100,000 today and never invest again. Here are the results:

The effect of expense ratios on investment returns

Year Investment A (1.25% expense ratio) Investment B (0.25% expense ratio) Difference
1 $106,750 $107,750 $1,000
5 $138,624 $145,240 $6,616
10 $192,167 $210,946 $18,779
20 $369,281 $444,985 $75,704
30 $709,637 $938,681 $229,044
40 $1,363,689 $1,980,118 $616,429
50 $2,620,560 $4,176,994 $1,556,434

As you can see, the expense ratio difference doesn’t make a huge difference up front. At the end of the first year, there is only a $1,000 difference. 

The difference increases to $229,044, or roughly 9.8% more than Investment A, after 30 years. 

After 50 years, the difference is even more pronounced at $1,556,434 or roughly 59.4% more than Investment A.

For the most part, you shouldn’t see expense ratios of similar funds varying by a whole percentage point.

The takeaway:

The lower you can get the expense ratio for the same service and returns, the more money you can keep for your future self.

Investment Companies Known for Low Expense Ratios

Some companies are well known for having relatively low expense ratios on the majority of their funds. 

In today’s competitive investment environment, expense ratios are being lowered to try to get people to move their investments to another company, as well.

In fact, Fidelity has gone as far as offering 0% expense ratios on certain funds.

Keep in mind:

Just because a firm is known for low expense ratios doesn’t mean all of their investments have low expense ratios or best in class expense ratios for a certain type of investment. 

Compare all of your options and consider consulting your financial advisor before choosing the right investment for you.

Here are a few of the top investment firms known for low expense ratios. 

Vanguard

Vanguard is often considered the pioneer of lowering investment costs for their investors. Part of the reason for this is the fact that Vanguard is owned by its funds. 

When you take things a step further, you realize that the people that own the funds actually own the company. If you invest in Vanguard funds, that’s you. 

As an investor owned fund company, it makes sense to keep the expenses as low as possible while still providing a quality investment experience.

Fidelity

Fidelity is also known for keeping their expense ratios low. In August 2018, Fidelity introduced the first zero expense ratio mutual funds, called Fidelity ZERO Index Funds. 

In addition to their low expense ratios, Fidelity offers no minimums to open accounts, no investment minimums and no account fees on certain funds.

Charles Schwab

Charles Schwab is another company that offers low cost funds as an option for your investments.

In particular, some of their index funds come with extremely low expense ratios with relatively small minimum investments.

Expense Ratios Aren’t the Only Factor to Consider

If you picked your investments solely based on the expense ratio, you probably aren’t going to be happy with your results. 

Expense ratios, while important, don’t take into account the many other factors you need to consider when you invest such as:

  • What each mutual fund or ETF invests in
  • Your time horizon for investing your money
  • Your risk tolerance
  • How each investment fits as part of your total asset allocation strategy
  • Fees to make trades such as sales loads
  • Other fees each investment may charge
  • Your goals for return on investment
  • How investments fit into your bigger financial plan
  • Whether you need to rebalance your portfolio
  • What type of account (taxable, retirement accounts, etc) you hold your investments in

Pick the Investment That’s Best for You

Expense ratios are only one factor you should look at when choosing an investment.

If an investment with a higher expense ratio is a better fit for your long-term goals, it may make sense to pay the higher fee. 

If you’re considering two similar funds that generally have the same goals and returns, it often makes sense to pick the investment with the lower expense ratio.

As always, make sure to consult your financial advisor before making any investment decisions. Your financial advisor can compare different investments and their expense ratios to your particular situation to find the investment that best fits your specific needs.


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