But what you might not realize is that each year, a percentage of your investment is going toward a fee known as an expense ratio.
No matter what you invest in, it’s always important to understand what fees you’re paying. And given the popularity of mutual funds and ETFs, many of us pay expense ratios out of our portfolios each year. In this article, you’ll learn what an expense ratio is, why it’s important, and how to identify a good expense ratio when you see one.
What Is an Expense Ratio?
An expense ratio is a fee that investors are charged by a mutual fund or exchange-traded fund (ETF). This fee covers the costs associated with administration, portfolio management, marketing, and more. These fees are usually percentage-based and represent an investor’s annual cost.
An expense ratio “helps inform investors as to what portion of the price of the ETF or mutual fund they bought is devoted to fund maintenance and other expenses,” said Bill Van Sant, a Senior Vice President and Managing Director at Girard Investment Services.
The expense ratio an investor pays for a fund is separate from any commission or other transaction fees they pay to invest. While transaction fees represent one-time costs when you buy or sell an investment, the expense ratio applies each year.
How Does an Expense Ratio Work?
In most cases, an expense ratio is the total costs of operating a fund divided by the fund assets. The higher those operational costs, the higher the expense ratio will be, which is why actively managed funds often have higher expense ratios. Actively managed funds are managed by a human, rather than a computer.
Check the expense ratio of any mutual fund or ETF before you invest. Quickly do the math to estimate how much you’ll pay each year in fees based on the amount you plan to invest.
As an individual investor, the amount you’ll pay each year is a percentage of the amount you have invested. For example, suppose an index fund has an expense ratio of 0.5% and you have $10,000 invested in the fund. You would pay about $50 per year in operational fees.
You won’t receive a bill for your portion of the fund’s expense ratio. Instead, the amount is deducted from your investment returns.
What Is a Good Expense Ratio?
tThe asset-weighted average expense ratio is 0.41%, according to 2020 data from Morningstar, down from 0.44% the previous year. A good rule of thumb is anything under .2% is considered a low fee and anything over 1% is high, according to many experts.
The higher the expense ratio, the more it’ll eat into your returns. Before investing, check the fees.
One of the most important factors that affect the expense ratio of a fund is whether it’s actively or passively managed. An actively managed fund has a fund manager who regularly buys and sells assets with the goal of beating the market. A passively managed fund, on the other hand, usually tracks the performance of a particular index or section of the market. These funds are known as index funds.
Because active funds require more hands-on work on the part of the fund manager, they also have higher average expense ratios than their passive counterparts. In fact, that same Morningstar data found that the average expense ratio for active funds was 0.62% in 2020, while the average for passive funds was just 0.12%.
Why Is It Important to Understand Expense Ratios?
When buy a pooled investment, you’re paying for a service. And just as you would expect to know the price of any other service you receive, it’s important to understand how much you’re paying in mutual fund or ETF fees each year.
“You wouldn’t start seeing a personal trainer without asking them how much they charge, would you?” asked Gabi Slemer, a Chartered Financial Analyst and the founder of Finasana, an online money management platform.
The expense ratio that you pay to invest in a particular fund is the percentage of your investment you’ll have to hand over to the fund company each year. These fees eat into your returns, and when you’re talking about long-term investing such as for retirement, expense ratios can add up to tens of thousands of dollars.
“Fees are really confusing, some argue on purpose,” Slemer said. “Expense ratios are quoted in percentage points, which to many people can sound pretty low. 1 to 2%? That’s nothing. Well, actually when you consider that your return may only be 10%, 2% is actually 20% of your entire return. Said differently, if you make 10% on $1,000 that’s $100. If you’re paying an expense ratio of 2%, you owe $20, meaning your actual return was only 8%, or $80.”