What Are Expense Ratios and Why Do They Matter?
A fund's annual expense ratio is a critical detail that directly impacts portfolio growth. Learn how this fee and other associated costs influence your returns over time.
An expense ratio represents the annual cost of owning a mutual fund or exchange-traded fund (ETF), expressed as a percentage of your investment. This fee covers the fund’s operating and administrative costs. For example, if you invest $10,000 in a fund with a 1.0% expense ratio, you will pay $100 per year in fees. These charges are not billed directly to you but are deducted from the fund’s assets, which in turn reduces the value of your investment.
Components of an Expense Ratio
An expense ratio is not a single charge but a combination of several costs required to operate a fund. The largest component is the management fee, which compensates the investment advisor for the research, analysis, and expertise required to manage the fund’s strategy. For actively managed funds, this fee is higher due to the hands-on approach required.
Another component is administrative costs, which cover the day-to-day operational expenses. This category includes record-keeping, customer service for shareholders, accounting services, legal counsel, and custodian fees paid to a third party for holding the fund’s securities.
Many funds also include 12b-1 fees in their expense ratio. Named after an SEC rule, these fees cover marketing and distribution expenses, such as advertising and payments to brokers who sell the fund’s shares. The idea is that attracting new investors can grow the fund’s assets, potentially leading to economies of scale that lower costs for everyone. FINRA rules cap these fees at 1% of a fund’s assets annually.
Associated Fund Costs Not in the Ratio
The expense ratio does not represent the total cost of owning a fund, as some charges are excluded. One of the most common are sales loads, which are commissions paid when you buy or sell shares. A front-end load is charged at purchase, while a back-end load is paid when you sell. These fees can range from 2% to 5%.
Investors may also incur brokerage commissions when buying or selling fund shares, particularly with ETFs that trade like stocks. While many brokers now offer commission-free trading for certain funds, it is not universal. These costs are paid directly by the investor to their brokerage firm.
A fund also has internal trading costs that are not included in the expense ratio. When a portfolio manager buys or sells securities within the fund, it incurs brokerage commissions and other transaction expenses. These costs are accounted for in the fund’s performance but are not itemized in the disclosed expense ratio.
Impact on Investment Returns
The effect of an expense ratio on an investment portfolio can be substantial over time due to compounding. The fee reduces the net return an investor receives each year, meaning you lose both the fee and the potential growth that money could have generated.
Consider an investment of $10,000 in two funds, both earning a 7% annual return before fees. Fund A has an expense ratio of 0.25%, while Fund B has a ratio of 1.00%. For Fund A, the net annual return is 6.75%, whereas for Fund B, the net return is 6.00%.
After 20 years, the investment in Fund A would grow to approximately $37,275. In contrast, the investment in Fund B would only reach about $32,071. The 0.75% difference in annual fees results in over $5,200 less in the final balance.
Locating and Evaluating Expense Ratios
The U.S. Securities and Exchange Commission (SEC) requires funds to disclose their fees in a standardized table in the fund’s prospectus, which is available on the fund company’s website. Investors can also find a fund’s expense ratio on financial information websites.
Whether an expense ratio is high or low depends on the type of fund. Passively managed funds, like index funds and many ETFs, track a market index and have lower operational costs. An expense ratio for a passive fund below 0.20% is common, with average fees around 0.11% in 2023.
Actively managed funds, where managers pick investments to try and beat the market, have higher costs due to research and frequent trading. For these funds, an expense ratio between 0.50% and 0.75% is considered reasonable, while anything above 1.5% is viewed as high. The asset-weighted average expense ratio for actively managed equity mutual funds was 0.65% in 2023. When comparing funds, it is important to compare similar types of investments to make a fair assessment of costs.