If you’ve looked into investing, chances are you’ve come across the term “expense ratio.” While you may be familiar with the term, it’s a good idea to thoroughly understand how it can affect your money.
When investing money, the goal is to maximize the return on all of your investments. This means trying to find investments that notably have the best returns. But, you should also be factoring in how much it will cost you to invest in a particular financial vehicle before moving forward. In other words, look for investments that offer lower or average expense ratios.
Here’s a look at how expense ratios are calculated, why they’re important, and how to identify a good expense ratio when you see one.
How do expense ratios work?
An expense ratio is a fee you pay each year when you invest in a mutual fund, exchange-traded fund (ETF), or index fund. These buckets of securities let you own many different assets with just a single investment. They can be valuable long-term investments, but what you might not realize is that each year, a percentage of your investment earnings is going toward expense ratio fees.
Expense ratios are expressed as percentages and represent the part of your total investment that’s deducted annually to help pay for the fund’s management and administration. An expense ratio is tied to an amount, so for example, a fund may charge a 0.40% expense ratio, which means you’ll pay $40 each year for every $10,000 you have invested in the fund.
Think of an expense ratio as the management fee paid to the fund company for giving you the ability to invest in the fund. You may also see these fees listed as “annual fund operating expenses,” but “expense ratio” is an umbrella term that can include several different fees, including:
- Portfolio management fees
- Marketing fees
- Administrative and maintenance fees
- Distribution or transfer of asset fees
- Legal and accounting expense fees
Gross expense ratio vs. net expense ratio
You may frequently see both “gross expense ratio” and “net expense ratio” references when investing. Fund companies will sometimes offer incentives to attract new investors through things like fee waivers and reimbursements. This is one of the main differences between gross and net expense ratios. Let’s take a closer look:
- Gross expense ratio: Gross expense ratio is the percentage an investor is charged without fee waivers and reimbursements. (You usually don’t need to worry about this number if there’s a net expense ratio.)
- Net expense ratio: 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.
In other words, the net expense ratio is what investors actually pay for access to a fund, and the gross expense ratio is what they might have to pay for access to the fund if things like promotional reimbursements are discontinued or taken away.
Types of expense ratios
Expense ratios can look different depending on the investment vehicle you choose. One of the most important factors that affect the expense ratio of a fund is whether it’s actively or passively managed.
An actively managed fund has a fund manager who routinely buys and sells assets with the goal of beating the stock market. A passively managed fund, on the other hand, usually tracks the performance of a particular index or section of the stock market, but doesn’t require as much legwork from the fund company.
What is a mutual fund expense ratio?
A mutual fund is a type of investment that collects money from investors to purchase stocks, bonds, and other assets. A mutual fund creates a more diversified portfolio than the average investor would be able to on their own. Because mutual funds invest in a lot of different companies, they can offer a lower risk to investors.
If a mutual fund is actively managed (which it usually is), it may entail more high-cost investment strategies, and thus have a higher expense ratio. It’s rare to see a ratio higher than 2.50%, and the industry average stands at about 0.50%.
What is an ETF expense ratio?
An exchange-traded fund (ETF) is a collection of securities such as stocks or bonds that gives an investor access to different markets. While this may sound just like a mutual fund, one big difference is that ETFs are traded on a stock exchange, and mutual funds are only traded once a day after the stock market closes.
Most ETFs are passively managed, so their expense ratios tend to be lower than most mutual funds. Since ETFs are simply tracking a benchmark index, there isn’t a need for a fund manager to conduct research and make trades. Since these costly activities are removed, the expense of operating the fund is lower. Expense ratios for ETFs tend to be lower than those for mutual funds, and the fees can start at as little as 0.05%.
What is an index fund expense ratio?
Index funds are passively managed funds, typically having low expense ratios. Index funds are diversified and work to track a specific section of the market or even the stock market as a whole, such as the Dow Jones Industrial Average or the S&P 500.
Passively-managed funds don’t require an active management team, which means that the expense ratio can be maintained on the lower side. So on the expense side, these naturally come in much lower. You can find several passively managed index funds that charge expense ratios below .05%.
What is a good expense ratio?
Expense ratios vary between funds and investments. Again, one of the most important factors that affect the expense ratio of a fund is whether it’s actively or passively managed. When considering expense ratios across mutual funds, ETFs, and index funds, it’s helpful to use average expense ratios as a benchmark to get an idea of whether a specific expense ratio is viewed as “good.”
The asset-weighted average expense ratio in 2021 for an actively managed mutual fund was 0.68%, according to the Investment Company Institute, which has been in a substantial decline over the past 25 years. A good rule of thumb to follow is anything under .2% is considered a low expense ratio fee, and anything over 1% is considered high.
How is an expense ratio calculated?
You can calculate an expense ratio, but generally, it’s given to you by the fund companies themselves. What you should calculate based on a fund’s expense ratio is how much money you’ll pay to the fund each year. It’s a good habit to have — this way you’ll always know how much money you’ll actually be earning off of your investments.
Expense ratio formula
Though individual investors typically won’t find themselves needing to calculate an expense ratio, it’s helpful to know how it’s done. To calculate an expense ratio, simply divide the fund’s total expenses (typically given to you) by the dollar value of your investment to figure out your total annual fee. Here’s an example using the equation:
Total Fund Expenses/Total Fund Assets Under Management = Expense Ratio
For example, if your assets in an investment fund are valued at $10,000 and there’s a 1% expense ratio for that fund, you will pay a fee of $100 per year.
$100 / $10,000 = .01 or 1%
Again, you normally won’t be tasked with calculating expense ratios yourself since they’re typically listed in your fund documentation or fact sheet.
How are expense ratios paid?
Expense ratios are paid every year by individual investors to the fund companies, but investors don’t actually have to do anything to make these payments. They’re automatically taken out from each investor’s balance. When that money is deducted depends on the fund, but whether it is deducted daily, weekly, or monthly, it still comes out to the same percentage each time.
What is an expensive expense ratio?
According to experts, generally anything less than 1% is considered a low expense ratio, and anything over that is viewed as high. And remember, the higher the expense ratio, the less your returns will be. Before investing, always check the fees and see if the fund is actively or passively managed, as that will affect the expense ratio in the end.
How can I find a fund’s expense ratio?
Can I avoid expense ratios altogether?
The short answer is no. Any fund you invest in will have operating expenses, so you can’t avoid them. But, don’t let that scare you away. If you look for funds with relatively low costs associated with them, you can save yourself more money in the long run.
Final thoughts: Does an expense ratio really matter?
Learning about the fees associated with anything related to your finances is essential, especially when it comes to investing. Investment fees can build up and eat into your returns, and if you’re focusing on long-term contributions, such as retirement, expense ratios can cost you a big chunk of change.
Remember, even a small difference in a fund’s expense ratio can result in a lot more fees paid or saved over time. If you’re not sure about what fees you’ll be charged when you invest, make sure to ask the fund company. When planning your investments, choose the fund that makes the most sense for your finances and timeline, while also considering expense ratios to help reach your goals.