An expense ratio is an annual fee charged to investors who own mutual funds and exchange-traded funds (ETFs). High expense ratios can drastically reduce your potential returns over the long term, making it imperative for long-term investors to select mutual funds and ETFs with reasonable expense ratios.
Understanding Expense Ratios
Expense ratios cover the operating expenses of a mutual fund or ETF, including compensation for fund managers, administrative costs and marketing costs.
“In the simplest terms, an expense ratio is a convenience fee for not having to pick and trade individual stocks yourself,” says Leighann Miko, certified financial planner (CFP) and founder of Equalis Financial.
For actively managed funds, the expense ratio compensates fund managers for overseeing the fund’s investments and managing the overall investment strategy. This includes the labor involved in selecting and trading investments, rebalancing the portfolio, processing distributions and other tasks to keep the fund on track with its goals and purpose.
If an actively managed fund employs high-profile managers with track records of success, you can expect it to charge a higher expense ratio.
For passively managed mutual funds and ETFs, which don’t actively select investments but instead aim to duplicate the performance of an index, the expense ratio covers things like licensing fees paid to major stock indexes—like S&P Dow Jones Indices for funds that track the S&P 500.
How Expense Ratios Are Charged
Expense ratios are usually expressed as a percentage of your investment in a fund. At first glance, it might be hard to figure out how much that means you’ll pay each year, but Steve Sachs, Head of Capital Markets at Goldman Sachs Asset Management, says it’s easier to digest if you look at expense ratios in dollar amounts.
For example, if a fund had an annual expense ratio of 0.75%, it would cost “$7.50 for every $1,000 invested over the course of a year—that’s what you are paying a manager to manage a fund and provide you with the strategy you’re accessing,” Sachs says.
What’s important to note about all expense ratios is that you won’t receive a bill. When you buy a fund, the expense ratio is automatically deducted from your returns. When you view the daily net asset value (NAV) or price for an index fund or ETF, the fund’s expense ratio is baked into the number you see.
How Expense Ratios Are Calculated
Expense ratios are calculated with the following equation:
Total Fund Expenses / Total Fund Assets Under Management = Expense Ratio
For example, if it costs $1 million to run a fund in a given year and that fund held $100 million in assets, its expense ratio would be 1%.
$1,000,000 / $100,000,000 = .01 = 1%
You normally won’t be tasked with calculating expense ratios yourself, though, as they’re typically noted in fund documentation.
How to Find a Fund’s Expense Ratio
The Securities and Exchange Commission (SEC) requires that funds publish their expense ratios in their prospectus. A prospectus is a document that outlines key information about ETFs and mutual funds, including investment objectives and fund managers.
If you use an online brokerage, you can usually find a fund’s expense ratio using the platform’s research tools. Many online brokerages also have fund comparison engines that allow you to enter multiple fund tickers and compare their expense ratios and performance side by side.
You may see both a gross expense ratio and a net expense ratio. The difference between these two figures has to do with some of the incentives fund companies use to attract new investors through fee waivers and reimbursements.
- Gross expense ratio is the percentage an investor would be charged without fee waivers and reimbursements. Investors don’t need to worry about this number if there’s a net expense ratio listed.
- Net expense ratio is the actual cost you’ll pay as an investor to hold shares of the fund after you receive the benefit of fee waivers and reimbursements.
Average Expense Ratios
Expense ratios vary widely, depending on the investment strategy used by the fund.
“The majority of ETFs are passive, index-based funds, which inherently have a lower expense ratio due to lower operating costs,” says Miko. “Mutual funds, on the other hand, can be both passive or active, so the expense range can vary a bit.”
According to Morningstar, expense ratios for both ETFs and mutual funds are trending downward. Its 2019 Annual Fee Study found the average expense ratios for open-end funds (funds that don’t limit the amount of shares investors can buy and sell on-demand) have nearly shrunk in half from 0.87% in 1999 to 0.45% in 2019.
Among actively managed funds, the average expense ratio in 2019 was 0.66%. For passively managed funds, the average expense ratio was 0.13% in 2019.
What’s a Good Expense Ratio?
“A reasonable range for a mutual fund expense ratio depends primarily on whether the strategy is active or passive,” says Miko. “For active funds that tend to require more trading and research, costs to maintain the fund are higher; thus the expense ratio is higher.”
For an actively managed mutual fund, Miko advises her clients that a reasonable expense ratio ranges between 0.40% for a domestic bond fund to around 1.0% for an international stock fund. For passive funds that simply mirror an index, Miko says costs for fund management are minimal and advises clients that expense ratios between 0.05% to 0.20% are reasonable.
Not all funds have expense ratios, though. For investors who are cost-conscious, Fidelity launched a line of no-expense ratio ETFs in 2018. There are currently four ETFs in this category.
Considerations Beyond Expense Ratios
An expense ratio shouldn’t be the only factor that guides an investor’s decision when comparing mutual funds and ETFs, though, says Sachs.
“Yes, a lower overall total expense ratio will help your investment grow at a higher rate, but other factors may have a larger impact, such as tax efficiency,” he says. “ETFs by design tend to be more tax-efficient than mutual funds. If having more control over when you pay taxes on your portfolio is important to you, one should consider that difference.”
Sachs also suggests investors consider how a particular fund fits into their portfolio and overall investment strategy. Just because it is the cheapest option doesn’t mean it’s the best option for your particular situation.
“Investors should weigh all the factors that will impact their particular portfolio. These factors may include taxes, the amount they trade and overall time horizon—just to name a few,” Sachs says.
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Expense Ratios and Investment Returns
Over time, expense ratios can have a significant impact on your returns from mutual funds and ETFs.
While an expense ratio may look like a small, one-time annual expense, your investment portfolio is actually hit with a double whammy. First, you’re charged the annual expense ratio on your current fund investment. Then, your lower returns are magnified by the smaller amount of money you have to compound over time.
Here’s how that might play out with two hypothetical funds:
You make an initial $1,000 investment in a fund with a 0.63% expense ratio, and then invest $6,000 a year for 30 years. The expense ratio would be equivalent to $6.30 per $1,000 invested. Assuming your fund earns an 8% average annual rate of return for 30 years:
- Before fees, your investment would be worth $744,137.86.
- After accounting for fees, it would be worth $659,029.93.
- The total expense ratio cost would be $85,107.93.
What if you choose a fund with a slightly lower expense ratio? With the same contributions and performance over time, a fund with an expense ratio of 0.31%, or $3.10 per $1,000 invested:
- Before fees, your investment would be worth $744,137.86.
- After accounting for fees, it would be worth $700,850.36.
- The total expense ratio cost would be $43,287.50.
Cutting your expense ratio more or less in half would have earned you an additional $41,829 for retirement. You might not see this potential chasm in returns simply by looking at the difference between $6.30 and $3.10 per $1,000 in expenses each year.
A fund with a lower expense ratio might not be the best match for all investors, however. There are several reasons you might opt to pay a higher expense ratio, including the fund’s historical returns, the desire to have a one-stop mutual fund in your portfolio like a target-date fund or a lower-risk fund with more capital preservation or income.
Whatever your choice, make sure you understand the impact of expense ratios on your investments and know whether you’re willing to bear the burden of the cost for the returns you seek.
How To Research Expense Ratios
Before you purchase an investment, be sure to research the funds you’re interested in. In addition to any tools your brokerage offers, several online tools make comparing funds and expense ratios easy:
- Morningstar. The most well-known ratings company for mutual funds and ETFs, Morningstar rates funds on a scale of one to five stars, with five being the highest-ranked across multiple criteria. Several online brokerages also include the Morningstar rating when you pull up an online quote for a fund. You’ll need to create a free account to use Morningstar’s fund comparison tool.
- John Hancock fund comparison engine. This free online tool helps you compare ETFs and mutual funds side by side, including expense ratios. The data that powers this John Hancock tool comes from Morningstar, but no account login is necessary to use it.
- Fund Visualizer. This free online tool helps financial advisors research and compare mutual funds, ETFs and indexes. Individuals can also create a free account to compare funds for a trial period.
As you compare investments, keep in mind that there’s no one-size-fits-all approach to mutual funds and ETFs, and expense ratios are only one component of an investment.
If you want more guidance about factors to consider when choosing investments, a financial advisor can help direct your investment choices. Those looking for a hands-off approach may consider a robo-advisor to keep costs low while maximizing potential returns.
