The expense ratio is the yearly fee that mutual funds and exchange-traded funds (ETFs) charge investors, to cover operating costs. The fee is deducted from your investment, reducing your returns each year.
Typically, investors may look for funds that offer lower expense ratios, as high expense ratios can take a substantial bite out of long-term returns, affecting investors’ financial plans.
Here’s a look at how expense ratios are calculated, what they encompass, and other factors worth considering when choosing a mutual fund or ETF to invest in.
How Expense Ratios Are Calculated
Though individual investors typically won’t find themselves in a situation where they need to calculate an expense ratio, it’s helpful to know how it’s done. To calculate expense ratios, funds use the following equation:
Expense Ratio = Total Fund Costs/Total Fund Assets Under Management
For example, if a fund holds $500 million in assets under management, and it costs $5 million to maintain the fund each year, the expense ratio would be:
$5 million/$500 million = 0.01
Expressed as a percentage, this translates into an expense ratio of 1%, meaning you would pay $10 for every $1,000 you have invested in this fund.
As you research funds you may come across two terms: gross expense ratio and net expense ratio. Both have to do with the waivers and reimbursements funds may use to attract new investors.
• The gross expense ratio is the figure investors are charged without accounting for fee waivers or reimbursements.
• The net expense ratio takes waivers and reimbursements into account, so it should be a lower amount.
How Expense Ratios Are Charged
A fund’s expense ratio is expressed as a percentage of an individual’s investment in a fund. For example, if a fund has an expense ratio of 0.60%, an investor will pay $6.00 for every $1,000 they have invested in the fund.
The cost of an expense ratio is automatically deducted from an investor’s returns. In fact, when an investor looks at the daily net asset value of an ETF or a mutual fund, the expense ratio is already baked into the number that they see.
The Components of an Expense Ratio
The fees that make up the operating costs of a mutual fund or ETF can vary. Generally speaking, the investment fees included in an expense ratio will include the following:
Management Fees
The management fee is the amount paid to the person/s managing the money in the investment fund—they make decisions about which investments to buy and sell and when to execute trades. Management fees can vary depending on how much activity is required of these managers to maintain the fund.
Custodial Fees
Custodial fees cover the cost of safekeeping services, the process by which a fund or other service holds securities on an investor’s behalf, guarding the securities from being lost or stolen.
Marketing Fees
Also known as 12b-1 fees, marketing fees are used to pay for the advertising of the fund, some shareholder services, and even employee bonuses on occasion. FINRA caps these fees at 1% of your assets in the fund.
Other Investment Fees
Investors may be forced to pay other investment fees when they buy and sell mutual funds and ETFs. The cost of buying and selling securities inside the fund is not included as part of the expense ratio. Additional costs that are not considered operating expenses include loads, a fee mutual funds charge when investors purchase shares. Contingent deferred sales charges and redemption fees, which investors pay when they sell some mutual fund shares, are also paid separately from the expense ratio.
How to Research Expense Ratios
Luckily, you do not have to spend your time calculating expense ratios on your own. The Securities and Exchange Commission (SEC) requires that funds publish their expense ratios in a public document known as a prospectus. The prospectus reports information important to mutual fund and ETF investors, including investment objectives and who the fund managers are.
Online brokers often allow you to look up expense ratios for individual investment funds, and they may even offer tools that allow you to compare ratios across funds.
Average Expense Ratios
Expense ratios vary by fund depending on what investment strategy it’s using. Passively managed funds that frequently track an index, such as the S&P 500, and require little intervention from managers, tend to have lower expense ratios. ETFs are usually passively managed, as are some mutual funds. Other mutual funds may be actively managed, requiring a heavier touch from managers, which can jack up the expense ratio.
Expense ratios have been falling for decades. The asset-weighted average expense ratio for mutual funds and ETFs dropped from 0.87% in 1999 to 0.45% in 2019 , according to the most recent Morningstar Annual U.S. Fund Fee study, released in June 2020. Expense ratios fell from 0.48% in 2018 to 0.45% in 2019. While that difference may seem slight, investors saved an estimated $5.8 billion in fund expenses in just one year.
That same Morningstar study found that the expense ratio for actively managed funds averaged 0.66% in 2019, while passively managed funds had a much lower average expense ratio of 0.13%.
What’s a Good Expense Ratio?
When considering expense ratios across mutual funds and ETFs, it’s helpful to use average expense ratios as a benchmark to get an idea of whether a specific expense ratio is “good”. Investors may want to target funds with expense ratios that are below average. The lower the expense ratio, the less expensive it is to invest in the fund, meaning more profits would go to the investor vs. the fund.
Looking Beyond Expense Ratios
When comparing mutual funds and ETFs, an investor might choose to consider other factors in addition to expense ratios.
It can be a good idea to consider how a particular fund will fit in their 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 know the key differences between mutual funds and ETFs. ETFs, for example, are generally designed to be more tax efficient than mutual funds, which can also have a big impact on an investor’s ultimate return.
The Takeaway
Expense ratios can have a big impact on investor returns. For example, if an individual invested $1,000 in an ETF with a 6% annual return and a 0.20% expense ratio, and continued making a $1,000 investment each year for the next 30 years, they would have earned $81,756.91, and spent $3,044.76 on the expense ratio. But expense ratios are ultimately one of many different factors to consider when choosing a mutual fund or ETF.
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The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
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 . 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.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
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