If you’re brand new to investing, it’s easy to be overwhelmed at the sheer number of different stock market terms that exist. Maybe the daunting task of learning all of the different vocabulary surrounding the stock market has even prohibited you from starting to invest your money.
After all, how can someone make important financial decisions without having an adequate base of knowledge first? This article will break down one specific term in a seemingly endless sea of investment words and phrases: expense ratio.
Learning about expense ratios could be the missing piece of knowledge that helps you take your first step towards investing today.
A Quick Investing Primer
In order to understand what an expense ratio is, it is first crucial to understand the basics of investing. Investing involves purchasing a monetary asset with the intent to capitalize on its value in the future. Typically, when an individual invests, he or she is doing so with the hope that the value of the chosen asset will increase over time.
When done mindfully and carefully, investing can play an important role in a person’s overall financial plan, offering potential to save for retirement, grow personal wealth, or save up for a large purchase, such as a house down payment.
Investing can have a greater potential for earnings than savings options but that opportunity comes with risk. While investing offers the possibility of returns, there are no guarantees and in some cases, investments can lose value.
Mutual Funds and Exchange Traded Funds
There are many ways to invest your hard-earned money for the chance to grow your wealth. For those extremely familiar with the stock market who are looking to take a more hands-on approach with their investments, individually picking and managing many different single investments might be appealing.
Both mutual funds and exchange-traded funds are made up of a mix of different assets and securities. This mix promotes diversification in one’s investment portfolio. In the world of investing, diversification is key because it can potentially reduce risk.
Due to the ever-changing nature of the stock market, it is actually not that advisable to “put all your eggs in one basket” financially; if you have most of your money tied up in one specific stock or security and that stock or security suddenly depreciated in an extreme way, you could potentially lose a lot of your money.
Thus, utilizing mutual funds and exchange-traded funds has the potential to be a good way to minimize the risk of possible great loss.
Generally speaking, mutual funds and ETFs differ in two key aspects: trading and management. While mutual funds can only be purchased at the end of the trading day at a calculated and set price, ETFs can be traded freely like stocks.
Another big difference is that mutual funds are very actively managed by a fund manager who makes direct decisions about how to distribute various assets in the fund; ETFs are generally more passively managed and based on a market index.
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Both mutual funds and ETFs incur various operational and management fees. These investment fees might include:
Management fees refer to the money paid to the person managing the money in your investment funds. This figure could vary widely depending upon the level of active management required to upkeep the fund.
Those funds that need individuals to manually sell and trade stocks could have a higher fee, while the more passive funds that rely on standard market indexes, such as the Dow Jones, S&P 500, and Nasdaq Composite, will probably require a much lower fee.
Custodial fees refer to the money that is paid to assist in the safekeeping of an investor’s funds. Safekeeping services—sometimes referred to as custody—refers to the process in which a fund or service holds securities on behalf of the investor in an attempt to guard the client’s assets from being lost or stolen.
Marketing fees, referred to as 12b-1 fees, are fees paid to help advertise funds. This can take the form of mailed brochures, online advertising, email outreach, and other forms of getting the word out about the fund.
Expense Ratio Explained
It could be a good idea to get familiar with a particular fund’s associated fees before choosing to invest in it. Knowing the cost of your investments could be crucial to making the best financial decision for your particular needs and goals. Which brings us to the question at hand: what is an expense ratio?
An expense ratio is the annual fee that covers the fund’s expenses. According to MorningStar , an expense ratio typically includes “12b-1 fees, management fees, administrative fees, and operating costs, and all other asset-based costs incurred by the fund.”
To calculate your expense ratio for any given investment, divide the annual expenses of that investment by the fund’s total value. That percentage is your expense ratio. Once you have determined your expense ratio, you can figure out the exact amount of money that you will owe for investing in your fund annually.
For example, if you invest $1,000 into an ETF that has an expense ratio of 0.2%, you will pay a $20 in fee every year. Expense ratios can be found on the fund’s website or other financial data websites.
Expense ratios tend to differ among mutual funds and ETFs. According to the Wall Street Journal , a mutual fund expense ratio averages about 0.74% while an ETF expense ratio tends to be lower, typically about 0.44%.
The reason for this general difference between a mutual fund expense ratio and an ETF expense ratio lies in the management fees associated with each type of fund.
Since ETFs are based off of a market index, they generally do not require as much management as a mutual fund. Thus, lower management fees, typically resulting in a lower expense ratio. When it comes to investing for a long-term goal, say retirement, expense ratios can have an impact on the bottom line.
A difference of 0.2% can add up to a substantial amount over 30, 40, or 50 years, so it can pay to be aware of a fund’s expense ratio and any other fees.
Investing with SoFi
With a better understanding of expense ratios, you might be ready to begin your investing journey. As you research investing options, consider SoFi Invest®, which offers a variety of investment options including automated investing and curated ETFs.
SoFi’s ETFs offer a low-cost option for investors to diversify their portfolio. SoFi has curated four ETFs, each intelligently weighted and affordably priced, specifically for ambitious investors with long-term goals for their investments.
The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.