Investment funds allow you to easily diversify your portfolio, with the peace of mind of knowing that a fund manager is doing all of the research for you. However, there are costs associated with managing a fund, which are passed on to investors. These costs are represented by the fund’s expense ratio.
While expense ratios have steadily declined over the last few decades, paying even a small percentage of your investment portfolio in fees can quickly add up, costing you thousands of dollars and impacting your long-term wealth. Understanding what an expense ratio is and how to spot a good one can help maximize your portfolio’s returns.
What is an expense ratio?
An expense ratio measures how much you’ll pay in investment fees over the course of a year to own an index fund, an exchange-traded fund (ETF), or a mutual fund.
“The expense ratio is meant to serve as a way to fund the operating expenses within the investment, which could include the money manager, compliance, administrative fees, or other costs,” says Nicole Birkett-Brunkhorst, a certified financial planner and wealth planner at U.S. Bank Private Wealth Management.
This fee eats into any investment income you earn, so it’s important to do your due diligence and compare a fund’s expense ratio with similar funds offered by competitors before investing.
How expense ratios work
The expense ratio represents the total percentage of a fund’s assets used for administrative and operational expenses. It’s charged on an annual basis and automatically deducted from the fund’s gross return, then paid directly to the fund manager. If you sell your fund before the expense is due, the amount is prorated, so you only pay operating expenses during the time you owned an investment in the fund, Birkett-Brunkhorst says.
For instance, if an index fund charges an expense ratio of 0.35% and you invested $15,000 for the entire year, you would pay $52.50 in fees. But if you sold your fund after owning it for six months, you may only pay $26.25.
Regardless of how much you pay each year, the expense ratio decreases your overall return earned on a fund. And though a fee of $50 per year may not seem so steep at first glance, it can quickly add up over time.
As an example, let’s compare the returns on index funds that have an expense ratio of 0.25%, 0.5%, and 0.75%. Here’s what your returns would look like if you invested $10,000 per year for 30 years with an annual return of 6%. (For simplicity’s sake, we’ll ignore commissions or other fees you may pay that aren’t included in the expense ratio.)
As you can see, your portfolio would grow over $70,000 more by investing in an index fund that charges an expense ratio of 0.25% versus 0.75%. Over time, your investment returns can be significantly reduced by the amount you pay in annual fees for fund management services.
What’s a good expense ratio?
The best expense ratio for investors is the lowest one available, since it puts more money in your pocket to reinvest or save, says Catherine Irby Arnold, senior vice president and Washington State market leader at U.S. Bank Private Wealth Management.
Since the late 1990s, expense ratios have declined significantly. As of 2021, the average expense ratio for actively managed equity mutual funds was 0.68%, down from 1.08% in 1996, according to the Investment Company Institute. The average expense ratio for index equity ETFs fell from 0.27% to just 0.16%. In fact, some funds have 0% expense ratios, such as the Fidelity ZERO Large Cap Index Fund. This is good news for investors, since a lower expense ratio can mean increased returns.
Generally speaking, an investment ratio above 1% is considered too high and should be avoided by most investors, since it far exceeds industry averages. But there may be instances when it makes sense to pay a higher expense ratio, depending on the type of fund you own and your objectives.
For instance, actively managed funds charge higher expense ratios since there is a team of investment managers who consistently review and rebalance the fund in hopes of earning higher returns. The cost of this additional research and involvement is passed on to the investor in the form of higher fees. On the other hand, a passively managed fund involves much less hands-on work,and therefore, requires less in fees.
How are expense ratios calculated?
The percentage you’ll pay annually in operating expenses toward the management of your fund is calculated using this formula:
Expense Ratio = Total Annual Operating Costs / Total Fund Assets
In this equation, “total annual operating costs” refers to all the expenses incurred by the fund to maintain its operation over a year, including fees for recordkeeping, taxes, legal expenses, or custodial services. “Total fund assets” simply means all the money that’s in the fund. Keep in mind that the expense ratio does not include one-time costs, such as sales commissions.
Luckily, you don’t have to calculate your expense ratio by hand. Your fund is required to disclose the expense ratio in the prospectus, and it can usually be found on the first few pages, according to Arnold.
The takeaway
Before investing in a fund, be sure you understand all the costs involved, including the expense ratio. Actively managed funds are more likely to have higher expense ratios than funds that are passively managed.
“The best expense ratio is the lowest expense ratio,” Arnold says. It’s important to compare a fund’s expense ratio with similar offerings so you don’t overpay for your fund’s management services. In general, an expense ratio over 1% may be too high for the average investor.
