One of the trickier lessons for investors to learn is how to judge an investment fund by its price. Part of the reason is that funds don’t refer to their fees as having a “price.” Instead, funds have something called an “expense ratio.”
“The expense ratio is the only certain reduction of your return,” said Mark Hebner, wealth advisor, president of Index Fund Advisors in Irvine, Calif., and author of “Index Funds: The 12-Step Recovery Program for Active Investors.” That’s why understanding expense ratios and knowing what to look for can help you maximize the returns on your investments.
What is an expense ratio?
The expense ratio is the ongoing fee you pay to invest in a mutual fund, index fund or exchange-traded fund (ETF). It’s expressed as an annual fixed percentage of your invested assets — for example, 1% or 0.70%.
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.
How expense ratios work
Investors are not presented with a bill each year that states how much is due. Instead, expense ratios are taken directly from the fund. The expense ratio accrues daily as a percentage of your average invested assets, which can make it easy to miss.
But the expense ratio does impact your investment performance. To get a sense of how much, consider the number in real dollars. Invest $1,000 in a fund with a 1.5% expense ratio, and you’ll pay about $15 each year. Invest $100,000, and you’ll pay $1,500.
You also may think of it 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 down by 11% after fees.
Like price tags, expense ratios may not be the only factor in your purchasing decision, but they can help you evaluate and compare investments. 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 0.5% expense ratio.
|Investment||Expense ratio||Annual cost on $10,000|
|Active mutual fund||2%||$200|
|Passive index fund||0.5%||$50|
Perhaps the more costly investment 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
If you are looking for a fund’s expense ratio, a good place to start is the prospectus, which is a detailed investment overview 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. Listed under the heading “Annual Operating Expenses” in the document will be a breakdown of all of the costs. Reading a prospectus isn’t everyone’s cup of tea, but it can be illuminating to see all the little line items that go into running a fund.
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, advisor or fund company, you can ask for a detailed explanation of the fees you will have to pay.
If you are so are 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?
“For the average person, you want the expense ratio to be as small as possible,” said Hebner.
The good news is average annual expense ratios have been on the long-term decline, falling by 40% over the past two decades. The average equity mutual fund expense ratio is currently 0.59%, according to the Investment Company Institute (ICI). The average bond mutual fund expense ratio is 0.48%.
Part of the reason expense ratios are declining is to keep up with index funds and ETFs, which tend to have below-average expense ratios, primarily because of lower operating costs and no active management fees. The average index equity mutual fund expense ratio is 0.09%, and the average index bond mutual fund expense ratio is 0.07%, according to the ICI.
Investors seem to be receiving the low-fee message. As of year-end 2017, the equity mutual funds with the lowest expense ratios hold more than three-quarters of total equity invested assets, according the ICI. Funds with the highest expense ratios hold only about 23% of the equity fund market. In August 2018, Fidelity began offering two no-cost index funds with a 0% expense ratio and then added two more the following month.
What’s not included in the expense ratio
There are additional fees not listed in the expense ratio that you may be charged 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). That amount typically is a percentage of the assets invested and decreases as you invest greater amounts. According to Morningstar, the typical front-end load might be 4% on an investment of $50,000 or less; a typical deferred load might be around 5% but might decrease if you stay invested over time. The Financial Industry Regulatory Authority limits the sales load on a mutual fund to 8.5%. With so many desirable no-load funds for investors to choose from, there is little reason to pay a load fee.
- 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 be charged this fee.
- Account fee. If there is an account minimum to meet, you may be charged a fee for falling below the minimum.
- 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. A 2013 academic study called “Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance” found that investors paid an average of 1.44% in trading costs per year — often more than they paid in management and operational fees.
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.
You should never select an investment simply because it’s cheap, and you may have your own good reasons to favor a fund with an expense ratio that is slightly higher than average. Being aware of the expense ratio is like knowing the price of something; it helps you make a decision based on your priorities. Just keep in mind that the higher the expense ratio, the harder it is to beat or even meet the investment’s benchmark.
With average expense ratios on the decline, finding a low-cost fund that fits you is easier than ever — and it can help boost your overall returns.