When it comes to investing, you’ve likely heard the arguments for
putting your hard-earned money into exchange-traded funds (ETFs) or
mutual funds to diversify your portfolio or to allocate more of your
portfolio toward conservative investments like bonds as you age.
Before you begin the investing process and siphon away thousands of
dollars for retirement or other future financial goals, there’s one
term you should absolutely familiarize yourself with: expense ratios.
Expense ratios can eat away at your investment earnings, so it’s
important to know what they are and how they work. Below, Select takes
a look at what expense ratios are, why they’re important and how they
can vary by fund type.
Defining expense ratios
An expense ratio is essentially a fee that investors pay for the
management of a fund — be it an index fund, mutual fund, and/or ETF —
which includes all administrative, marketing, and management fees. Try
and think of it this way:
Expense Ratios = the fund’s net operating expenses / the fund’s net assets
Expense ratios are typically represented as a percentage. An expense
ratio of 0.2%, for example, means that for every $1,000 you invest in
a fund, you’ll be paying $2 annually in operating expenses. These
funds are taken out of your expenses over time, so you won’t be able
to avoid paying them. Just as your returns are magnified because of
compound interest, your expenses are as well, which is why there may
be a big difference in earnings if you choose to invest in a fund with
a high expense ratio.
Let’s take a look at this example: You invest $5,000 a year and
receive a constant 7% annual rate of return on your investments.
According to the chart below, your earnings would be at least $25,000
more if you invested in the fund with a 0.3% expense ratio versus the
fund with a 0.6% expense ratio.
Actively vs. passively managed funds
Depending on the type of fund you’re investing in, expense ratios can
vary greatly. Actively managed mutual funds typically have a higher
expense ratio than passively managed funds, mainly because passively
managed funds don’t have managers and researchers who are actively
choosing assets to buy and sell.
Over the past 20 years, expense ratios among all funds — including
both passive and active — have been trending downward. According to
Morningstar’s 2020 U.S. Fund Fee Study, the asset-weighted average
expense ratio fell to 0.41% in 2020 from 0.93% in 2000. Note that
Morningstar uses an asset-weighted average, which weighs funds
according to their size.
On the other hand, passively managed exchange-traded funds tend to
have low fees since they aim to match the performance of the market,
not beat it. The asset-weighted average expense ratio for actively
managed funds was 0.62% in 2020 — for passively managed funds, it was
only 0.12%.
As far as passively managed funds, index funds are a popular option
among investors since they track a specific stock index and aim to
match its rate of return. For example, investors can find low fee
index funds that track the S&P 500, a popular stock index that tracks
the largest 500 U.S. companies based on market capitalization.
Fidelity started offering investors 0% expense ratio index funds in
2018.
Investing on your own
You can start investing in mutual funds or exchange-traded funds
through a retirement account or on your own. Whether you’re investing
in a Roth or traditional IRA or your employer’s 401(k), most
retirement accounts provide investors with a variety of options — you
may be able to invest in actively or passively managed mutual funds,
exchange-traded funds, or even individual stocks or bonds. Select
ranked Vanguard, Charles Schwab, Fidelity Investments, and E*TRADE as
the companies offering the best IRAs.
For investors who prefer a more hands-off approach, Robo-advisors can
be a good choice since they use an algorithm to curate your investment
portfolio, periodically buying and selling investments based on your
personal financial goals. Robo-advisors typically charge a management
fee, which, like an expense ratio, is represented as a percentage.
For example, having an annual management fee of 0.25% means you’ll
have to pay the Robo-advisor company $25 for managing $10,000 of
investments. Keep in mind that this fee is charged on top of the
expense ratio you’ll have to pay for each fund you’re invested in.
Select ranked Betterment and Wealthfront as the best Robo-advisor
services.
Bottom line
While investing can be a great source of passive income, if you’re
unaware of the fees you’ll have to pay in the process, you could be
earning less money than you think. It helps to be aware of the expense
ratio, which includes all administrative, marketing, and management
fees and is essentially the ratio of the fund’s net operating expenses
to the fund’s net assets.
Actively managed funds typically have higher expense ratios because
investors are paying for the potential to have a higher return. In
contrast, passively managed funds like index exchange-traded funds
typically have lower expense ratios because they only aim to perform
as well as the overall market.