The expense ratio is an annual fee charged to investors by fund managers to cover operational expenses. The cost is deducted from the client's investment, thereby lowering annual earnings.
Investors would generally prefer funds with lower cost ratios since high expense ratios may eat into long-term returns, causing investors' financial goals to suffer. This article highlights how expense ratios are determined, what they cover, and other things to think about when picking a mutual fund or ETF.
Even though most individual investors may never need to compute an expense ratio, knowing how to do so is useful. Funds use the following formula to compute expenditure ratios:
Expense Ratio = Total Costs/Total Assets Under Management
For example, if a fund manages $100m in assets and it costs $1 million to operate the fund each year, the expense ratio is: $1m / $100m = 0.01. When expressed as a percentage, this corresponds to a 1% expense ratio, which means that for every $1,000 invested in this fund, you will pay $10.
When looking for funds to invest in, you'll come across two terms: gross expense ratio and net expense ratio.
Both are related to the exemptions and reimbursements that funds could utilize to entice new investors. The gross expense ratio is the amount charged to investors before any fee waivers or refunds are taken into account.
Waivers and reimbursements are taken into account when calculating the net expense ratio, which makes it lower.
A fund’s expense ratio is expressed as a percentage of an individual’s investment in a fund.
From the example above we can see that at an expense ratio of 1%, the investor would pay $10, for every $1000 invested in the fund. Expense ratios are subtracted from an investor's returns automatically. When an investor examines the daily net asset value of a fund, the expense ratio is already factored into the figure.
There are a plethora of fees that make up the expense ratio but have in mind that the components of a fund's operating costs can vary. In general terms, the investment fees included in an expense ratio will include the following:
The cost of having an investment fund professionally managed by an investment manager is known as management fees.
The management fees include not only the expense of paying the managers but also investor relations and any other administrative expenditures.
Management costs vary depending on the investment strategy employed by the fund's management. The more the management fees charged, the more actively managed a fund is.
A fund that engages in active trading of funds would have higher management fees than one that engages in passive trading.
Custodial fees are costs that you'll pay to the fund for safekeeping your investments.
But it also goes beyond this. The fund also performs a host of other tasks that could become overwhelming if you had to deal with the duties yourself. For example, the fund collects your dividend and interest income for you, gives you an account statement and handles any corporate actions.
Custodial fees vary according to fund and account type.
A fund's yearly marketing or distribution charge is known as a 12b-1 fee.
The 12b-1 fee is considered an operating expenditure and is thus included in the expense ratio of a fund. It is believed that the 12b-1 fee is designed to benefit investors.
This is based on the assumption that by promoting a fund, its assets will grow and management would be able to cut costs due to economies of scale. This, on the other hand, has yet to be confirmed.
The 12b-1 fee is typically 0.25 percent to 0.75 percent of a fund's net assets, but FINRA restricts these fees to 1% of your assets in the fund.
When buying and selling mutual funds and ETFs, investors may be obliged to pay additional investing costs.
The expense ratio does not include the cost of purchasing and selling securities within the fund. Loads, a fee charged by mutual funds when investors acquire shares, are an example of additional charges that are not considered operational expenses.
Contingent deferred sales charges and redemption fees are paid separately from the expense ratio when investors sell some mutual fund shares. That's a separate type of cost, and you should do everything you can to avoid funds that charge them.
Fortunately, you won't have to waste time figuring out expense ratios on your own.
The Securities and Exchange Commission (SEC) requires funds to disclose their expenditure ratios in a prospectus. This is a public document that contains critical information for mutual fund and ETF investors, such as investment objectives and fund management.
Expense ratios for specific investment funds are frequently available through online brokers, and some even provide tools that allow you to compare ratios across funds.
Expense ratios differ based on the investment strategy employed by the fund.
Lower expense ratios are common in passively managed funds that closely track an index, such as the S&P 500, and need little management involvement. ETFs, like certain mutual funds, are typically managed passively.
Other mutual funds may be actively managed, which necessitates a more hands-on approach from managers, raising the expense ratio.
For decades, expense ratios have been declining. According to the June 2020 Morningstar Annual U.S. Fund Fee report, the asset-weighted average charge ratio for mutual funds and ETFs fell from 0.87% in 1999 to 0.45 percent in 2019.
Actively managed funds had an average cost ratio of 0.66% in 2019.
Passively managed funds had an average expense ratio of 0.13%.
Expense ratios decreased in 2019 from 0.48% in 2018 to 0.45%, saving investors an estimated $5.8 billion in fund expenditures in only one year, despite the little difference.
Comparing expense ratios between funds using market average as a baseline might help you determine if a certain expense ratio is "good" or not.
The rule of thumb is investing in funds with lower-than-average cost ratios. The smaller the cost ratio, the cheaper it is to invest in the fund, which means more gains go to the investor rather than the fund.
However, there is a caveat here, as funds with a higher expense ratio may offer their clients certain benefits and services which firms with a lower expense ratio may not be able to.
It's good to keep an eye on the expense ratio. But it's also noteworthy to consider this metric in relation to your overall financial plan.
For example, individuals looking to build a diversified portfolio may want to target a fund that tracks a broad index like the Nasdaq or S&P 500. Or, investors with portfolios heavily weighted in domestic stocks may be on the hunt for funds that include more international stocks.
And it’s also a good idea to consider how the structure of the fund and its unique characteristics as this could have a greater impact on investments than the expense ratio.
For example, the differences between funds (i.e. mutual funds, index funds, ETFs, etc.) denote different rates of returns for an investor because of the way each one is structured. For example, ETFs are traded like stocks, unlike mutual funds whose unit prices are calculated at the end of the trading each market day.
Expense ratios can have a big impact on investor returns.
For example, an individual invests $1,000 in an ETF with a 6% annual return and a 0.20% expense ratio. They continue making a $1,000 investment each year for the next 30 years. At the end, they would have earned $81,756.91, and spent $3,044.76 on the expense ratio.
Expense ratios are ultimately one of many different factors to consider when choosing a fund.
The structure of the fund, investment style, and broader macroeconomic conditions may also have a greater weight on your portfolio. As such, expense ratios should be considered as a subset of many factors that can affect your investment, and not as an isolated factor.
Photo by Anne Nygård on Unsplash
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