Investors looking to put their money into mutual funds or exchange-traded funds (ETFs) should pay close attention to the expense ratio. This ratio reflects the annual cost of owning a fund and can have a significant impact on returns. Expenses like fund management, marketing, and other operational costs are covered by the expense ratio. Both mutual funds and ETFs come with an expense ratio.
Understanding expense ratios is crucial when evaluating the cost of investing in a fund. Here’s how expense ratios work and what makes a good expense ratio.
Understanding Expense Ratios
An expense ratio represents the cost of owning a mutual fund or ETF. It is essentially the management fee paid to the fund company for holding the fund.
The expense ratio is calculated as a percentage of your investment in the fund. For instance, if a fund charges 0.30 percent, you would pay $30 per year for every $10,000 invested in that fund.
This fee is paid annually as long as you hold the fund for the year. For ETFs, the fee is deducted from the fund’s net asset value daily, making it transparent to the investor.
Importance of Understanding Expense Ratios
Investors should be aware of what they are paying for when investing in mutual funds and ETFs. A high expense ratio can result in significantly higher costs, potentially negating returns. An expense ratio exceeding 1 percent is considered high and should be avoided. Over time, a low expense ratio can save investors a substantial amount of money, making a significant impact on their retirement savings. While many investors opt for funds with higher expense ratios if the benefits outweigh the costs, it is generally advisable to choose funds with lower expense ratios.
Expense ratios have been decreasing over the years, particularly for passive funds. Some passive funds now have expense ratios below 0.10 percent, with a few even charging 0 percent, which is a favorable scenario for investors.
What Constitutes a Good Expense Ratio?
To determine the quality of an expense ratio, it can be evaluated in two ways:
- Comparing it to the simple average of all funds to gauge its overall ranking.
- Comparing it to the asset-weighted average of all funds to assess if you are obtaining a better price than most other investors.
Generally, investors should aim for a fund with an expense ratio below the asset-weighted average, as lower costs are preferable.
The assessment of whether an expense ratio is good largely depends on the options available in the industry. A downward trend in expense ratios has been observed over the years, with cheaper passive ETFs gaining more assets and prompting traditional mutual funds to lower their expense ratios.
Three key points can be noted from this graphic:
- Average expense ratios have significantly decreased over the past two decades for both stock mutual funds and stock ETFs. Fees on stock mutual funds dropped from 0.99 percent in 2000 to 0.42 percent in 2023 on an asset-weighted basis.
- The unweighted average is higher than the asset-weighted average, standing at 1.11 percent in 2023. This figure represents the average cost if funds were selected randomly.
- Expense ratios on index stock ETFs typically start at a lower level and have also seen a decline over the last two decades. The asset-weighted average in 2023 was 0.15 percent, lower than the simple average of 0.47 percent, indicating a preference for cheaper funds.
It is noteworthy that while mutual funds generally have higher expense ratios, a subset of them, such as stock index funds, offer considerably lower fees.
The asset-weighted average for stock index mutual funds, which are passively managed, decreased from 0.27 percent in 2000 to 0.05 percent in 2023. These funds are popular choices in employer-sponsored 401(k) plans and compete favorably with passively managed ETFs.
Some of the most affordable funds are index funds linked to the S&P 500 index, charging less than 0.10 percent, and some even offer zero fees.
Impact of Expense Ratios on Returns
Expense ratios directly impact the rate of return on your portfolio. Investors should consider the effects of both high fees and compounding. While compounding can enhance investment returns over time, it also applies to fees, as they are calculated as a percentage of your fund position.
As your portfolio balance grows, fees consume a larger portion of your assets. For example, if your $10,000 portfolio grows to $1 million and you are charged a 1 percent fee, you would be paying $10,000 annually, equivalent to your original portfolio balance. This fee is recurring each year and can have a substantial long-term impact.
Despite the benefits of compounding, certain mutual funds charge fees that can accumulate to significant amounts. Mutual funds generally have higher fees than ETFs due to fund management expenses. Comparatively, an index fund with a 0.03 percent fee would result in a $300 charge on a $1 million portfolio. Fees can significantly affect returns, emphasizing the importance of considering them.
Calculation of Expense Ratios
Expense Ratio (Percentage) = Total Annual Fees Charged / Your Total Investment
Fund expenses directly influence your fees, with actively managed funds typically having higher expense ratios than index funds. Index funds are passively managed and linked to the performance of an index, like the S&P 500.
Other costs included in a fund’s expense ratio are taxes, legal fees, accounting, auditing, and recordkeeping. While operating expenses may vary for mutual funds, the expense ratio tends to remain relatively stable. Larger mutual funds often maintain consistent expense ratios from year to year, even amid a downward trend.
Additional Considerations on Expense Ratios
Experts recommend selecting low-cost funds to avoid significant fees throughout an investment career. In addition to direct fees, investors also forfeit the compounding value of their funds. Calculating the long-term cost of fees is essential.
For instance, a one-time investment of $10,000 in a fund with a 1 percent expense ratio, earning the market’s average return of 10 percent annually over 20 years, would incur total fees amounting to $12,250. Larger funds can typically charge lower expense ratios by spreading costs across a broader asset base. Smaller funds may initially have higher expense ratios but can reduce them as they grow.
While mutual funds may levy sales loads, a separate type of fee, these are not included in the expense ratio. Investors should avoid funds with sales loads and opt for mutual funds with low expense ratios. Many major brokers offer a wide range of mutual funds without sales loads and with competitive expense ratios.
Finding Funds with Low Expense Ratios
High expense ratios can lead to substantial costs, but investors can identify funds with low expense ratios through various means. Notable points to consider include:
- Most ETFs are passively managed index funds, making them relatively low-cost compared to the average mutual fund.
- Index mutual funds are also passively managed and generally cheaper than ETFs overall, though mutual funds have certain drawbacks compared to ETFs.
- Funds based on major indices like the S&P 500 typically offer some of the lowest expense ratios.
Starting with S&P 500 index funds, whether in ETF or mutual fund form, is a good strategy due to their low expense ratios. ETFs are often preferred for their cost-effectiveness.
For investors willing to conduct some research, top brokers for ETF investing provide screeners to filter high-performing, low-cost funds. Platforms like Charles Schwab and Fidelity Investments offer robust tools for fund selection. Bankrate has also identified top low-cost ETFs across various market segments.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Past performance of investment products does not guarantee future price appreciation.