An expense ratio measures how much of a fund’s assets are used for administrative and other operating expenses. They are calculated by dividing a fund’s operating expenses by the average dollar value of its assets under management (AUM). The expense ratio, which is calculated annually and disclosed in the fund’s prospectus and shareholder reports, directly reduces the fund’s returns to its shareholders, and, therefore, the value of your investment.
An expense ratio is important as it lets an investor know how much they are paying to invest in a specific fund. All things equal, the lower the expense ratio the better, because it means an investor is keeping more of the returns on their invested capital (not paying as much out).
Expense ratios are going to vary depending on the type of fund. Index funds tend to have lower expense ratios as they are less costly to manage. The managers of these funds are generally replicating a given index. The associated management fees are thus lower due to the lack of active management, as with the funds they mirror. Actively managed funds employ teams of research analysts examining companies as potential investments. Those additional costs are typically passed on to shareholders in the form of higher expense ratios.
Over the past two decades, fund expenses have trended significantly lower, and now many index ETFs offer expense ratios as low as 0.03% per year. According to a report published by the Investment Company Institute (ICI) titled “Trends in the Expenses and Fees of Mutual Funds, 2018” (the most recent such report), expense ratios incurred by investors in long-term mutual funds have, on average, declined substantially for more than 20 years. In 1997, equity mutual fund expense ratios averaged 1%, falling to 0.55% in 2018. Hybrid funds went from 0.92% to 0.66%, and bond funds dropped from 0.82% to 0.48%.
In general, the expense ratios for mutual funds tend to be higher than for ETFs. The costs of operating funds vary greatly depending on the investment category, investment strategy and the size of the fund, and those with higher internal costs generally pass on these costs to shareholders through the expense ratio. If a fund’s assets are small, for example, its expense ratio might be relatively high, because the fund has a smaller asset base from which to meet its expenses.
An awareness of expense ratios helps you keep more of your money working for you instead of going toward a fund’s operating costs. That’s why most experts recommend a diversified portfolio of low-fee, passive ETFs.
At Aspire Wealth, we think it’s important to be fee conscious, which is why we deploy low-cost ETF portfolios to ensure we’re keeping costs low while still providing professional asset management. We’re here to help if you have any questions about expense ratios and the impact they can have on your portfolio.
Ben Webster, CFP® and Derek Prusa, CFA, CFP®
Co-Founders and Owners of Aspire Wealth
May 2021 Newsletter
