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Updated on Wednesday, January 6, 2021
An expense ratio is the ongoing fee you pay to invest in a mutual fund, index fund or exchange-traded fund (ETF). Like with any fee, a fund’s expense ratio reduces your existing assets.
The expense ratio is automatically deducted, rather than charged in an end-of-the-year bill. If you don’t pay attention, you can miss the expense ratio getting taken from your returns. That’s why it’s important to understand expense ratios and know what to look for so you can better minimize their impact on your investments.
- What is an expense ratio?
- Expense ratio effect on returns
- How to find a fund’s expense ratio
- What’s a good expense ratio?
- What’s not included in the expense ratio
- How to control investing costs
What is an expense ratio?
A fund’s expense ratio accrues daily as an annual fixed percentage of your invested assets — for example, 1% or 0.70% of your assets. If you invest in a $1,000 fund with a 1% expense ratio, you would pay $10 for that fund’s expense ratio fees in the first year.
Included in the expense ratio are the costs of running the fund, from operations to administration, with small charges for accounting, legal, custodial or other service costs. If the fund is actively managed, the bulk of the expense ratio will go toward the investment advisory fee. There’s also something called a 12b-1 fee, or distribution fee, which some funds charge to pay for marketing to new investors.
Expense ratio effect on returns
Since the expense ratio is deducted from your assets, it reduces your returns throughout the year and over the fund’s lifetime. Of course, the higher the expense ratio, the bigger the cut it takes.
To get a sense of how much you lose from an expense ratio, let’s consider the number in real dollars. In the example outlined in the table below, let’s say you invest $1,000 into a fund with an average annualized gain of 5%.
|A Look at How Expense Ratios Can Impact Your Returns|
|Year||5% gain||0.50% expense ratio||1% expense ratio||2% expense ratio|
The 5% gain column is what your balance would be after each year without incurring an expense ratio. The dollar amounts listed under each expense ratio amount indicate what your balance would be after the expense ratio is assessed each year. We also included the dollar amount and percentage loss from the various expense ratios at the bottom of the table.
You also may think of expense ratio effects as a haircut of sorts in your annual performance. If your fund with a 1% expense ratio is up 10%, you will have returns of 9% after paying for the cost of the fund. That may not sound so terrible in good times, but it can be harder to bear in volatile markets — for example, when the fund is down by 10% for the year and you are really down by 11% after fees.
Expense ratios may not be the only factor in your purchasing decision, but they can help you evaluate and compare investment opportunities. Say you have $10,000 to invest and are considering an actively managed mutual fund with a 2% expense ratio to an index fund with a 0.50% expense ratio — here’s how they’d stack up:
|Investment||Expense ratio||Annual cost on $10,000|
|Active mutual fund||2%||$200|
|Passive index fund||0.50%||$50|
Perhaps the more costly mutual fund adds value — enhanced performance returns, steady dividends, risk management — in a way that justifies its higher annual expenses. On the other hand, the mutual fund will have to outperform its benchmark by 1.5% just to keep up with the index fund.
How to find a fund’s expense ratio
The fund’s prospectus: If you’re looking for a fund’s expense ratio, a good place to start is the prospectus, which is a detailed investment overview that funds must file with the U.S. Securities and Exchange Commission (SEC). You can get a printed copy of a prospectus by contacting the fund company directly, and most fund websites include links to digital copies. Or you can find a prospectus on SEC.gov by searching for the name of the fund or fund company. Under the document heading “Annual Operating Expenses,” you can find a breakdown of all of the costs.
Research websites or the fund company or broker: There are also some great websites — including Morningstar, MAXfunds and Kiplinger — that can give you a peek at a fund’s fees and help you compare low-cost options. When purchasing a fund from a broker or fund company, you can ask for a detailed explanation of the fees you will have to pay. You can also talk this over with a registered financial advisor.
DIY calculations: If you are so inclined, you can calculate a fund’s expense ratio on your own by dividing total operating expenses by the average dollar amount of assets under management (often referred to as AUM).
What’s a good expense ratio?
Knowing how to calculate an expense ratio is one thing. But how do you know whether the expense ratio is good or bad? In general, a good expense ratio is at or around 0.50%. If you want to get more specific, a good expense ratio is one that is at or below the average ratio for a certain fund.
|Average Expense Ratios By Fund Type|
|Fund||Average expense ratio in 2019|
|Equity mutual fund||0.52%|
|Bond mutual fund||0.48%|
|Hybrid mutual fund||0.62%|
|Target date mutual funds||0.37%|
|Money market funds||0.25%|
|Index equity mutual fund||0.07%|
|Index bond mutual fund||0.07%|
Typically, you want the expense ratio to be as low as possible, so it takes less of a bite out of your investments.
The good news is that average annual expense ratios for mutual funds have been on the long-term decline, falling by over 40% over the past two decades. Part of the reason that expense ratios are declining is to keep up with index funds and exchange-traded funds (ETFs), which tend to have below-average expense ratios, primarily due to lower operating costs and a lack of active management fees.
What’s not included in the expense ratio
There are additional investment fees not listed in the expense ratio that you could face when investing in a fund. Some can be avoided. Here is a rundown of what to look out for.
Under the general category of shareholder fees in the prospectus are several potential charges:
- Sales loads: Some funds are sold through brokers who are compensated by fees paid by investors. These fees are known as loads or sales loads. They might be taken off the top of your investment when you purchase shares in the fund (front-end loads), or you may pay a deferred cost when you take your money out (deferred loads). FINRA limits the sales load on a mutual fund to 8.5%.
- Redemption fee: This is a transaction cost some funds charge when you redeem your fund shares. It is different from a deferred sales load because the fee does not go toward a broker’s compensation but pays the fund to defray the costs shared by all fund investors when you redeem shares in the fund. The SEC limits redemption fees to a maximum of 2%.
- Exchange fee: If you exchange one fund’s shares for another, you may owe this fee.
- Account fee: If there is an account minimum to meet, you may face a fee for falling below it.
- Purchase fee: This is a transaction cost some funds charge when you purchase shares. Similar to the redemption fee, this differs from a sales load because it pays the fund to defray the shared costs associated with your purchase.
If there is trading going on in the fund, there will be associated broker and transaction costs. In actively managed mutual funds where a lot of trading can occur, these fees can take a toll. If you are buying an ETF, you also should pay attention to the trading costs you pay when buying and selling shares.
As the fund buys and sells investments, capital gains and losses are incurred. All fund investors share the tax burden, which is paid for with fund assets. Taxes are a hidden fund cost that can take a toll on your investments.
How to control investing costs
While you can’t dictate a fund’s expense ratio, you can control which funds you choose and how their prices affect your returns. That’s why it’s important to check a fund’s expense ratio and compare it against other potential investments, as well as average prices. That can help you make a decision based on your own financial goals and priorities.
That being said, you should never select an investment simply because it’s cheap, and you may have your own reasons to favor a fund with an expense ratio that is slightly above average. Just keep in mind that the higher the expense ratio, the harder it is to beat or even meet the investment’s benchmark.
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