Expense Ratio Basics for Comparing Mutual Funds, ETFs

Identifying and picking individual investments successfully is hard for many folks, which is why mutual funds and exchange-traded funds (ETFs) exist.

These funds allow investors to pool their dollars to buy assets, and both ETFs and mutual funds come with a method, if you will, of selecting assets.

Unfortunately, not all of these mutual investments perform the same or even cost the same, and for us, something that is too often forgotten about is a given fund's expense ratio.

Bottom line, it's not enough to merely pick funds that have shown strong past performance. Understanding the subtleties and nuances of the investment landscape, such as the aforementioned expense ratios, can significantly impact your long-term financial health. It's a factor that can mean the difference between a comfortable retirement and one fraught with financial worries.

What to Expect

So, what exactly is an expense ratio? What expenses does it encompass? How does it apply to mutual funds and exchange-traded funds (ETFs)? And how does it affect your investments, especially when it comes to passively versus actively managed funds?

In this article, we will delve into the concept of expense ratios, breaking it down into comprehensible terms for the everyday investor. We will explore the different types of expenses included in this ratio, illustrate its significance in mutual funds and ETFs, and contrast the effects of expense ratios in passively and actively managed funds. We will even provide a tin-cup-sized example.

Understanding Expense Ratios

As you know, when you invest in a mutual fund or an ETF, you're not just putting your money into a single stock or bond. Instead, you're buying a piece of a diversified portfolio managed by professionals who make investment decisions on your behalf (or passively).

These services, however, come with a cost —and that's where the expense ratio comes into play.

Simply put, an expense ratio measures what it costs to operate a mutual fund or an ETF. Expressed as a percentage, it represents the portion of your investment that is taken out annually to cover these operational costs.

For example, if you invest $10,000 in a fund with an expense ratio of 0.50%, you will pay $50 per year for the fund's operational expenses. Remember that this fee is deducted regardless of whether the fund has a positive or negative return.

So, what types of expenses are included in the ratio? Generally, the expense ratio covers management fees (which pay for the services of the fund's portfolio managers), administrative costs (like record keeping, customer service, and legal or accounting fees), and 12b-1 fees (which go towards the costs of marketing and distribution). Some expense ratios also include transaction costs incurred when the fund buys or sells securities. However, it's important to note that transaction costs are often treated separately and may not always be included in the stated expense ratio.

The size of the expense ratio can vary widely from one fund to another, and several factors determine it. These factors include the fund's size (large funds often have lower expense ratios due to economies of scale), investment strategy (funds that require more research or that trade more frequently typically have higher costs), and whether the fund is actively or passively managed (more on this in a later section).

Calculating Expense Ratio

Expense Ratio = (Total Fund Expenses / Total Fund Assets) x 100%

Let's break down each part:

Total Fund Expenses —these are the total cost of operating the fund, including management fees, administrative costs, 12b-1 fees (if applicable), and sometimes transaction costs.

Total Fund Assets —the total amount of money invested in the fund.

You get the expense ratio as a percentage by dividing the total expenses by the total assets and multiplying by 100 percent. This percentage tells you how much of the fund's total assets are used to cover operating expenses yearly.

For example, if a mutual fund has $2 million in total expenses and $100 million in assets under management (AUM), its expense ratio would be:

Expense Ratio = ($2,000,000 / $100,000,000) x 100% = 2%

For every $100 you have invested in the fund, $2 goes toward the fund's operating costs.

In the following two sections, we will get a little more specific, taking mutual funds and ETFs in turn.

Expense Ratios in Mutual Funds

Mutual funds pool money from a multitude of investors to create an extensive, diversified portfolio.

As an investor, you buy shares in the fund, and your investment rises and falls in value in line with the fund's underlying assets.

Operating these funds, however, comes with various costs —from paying the fund's manager to administrative expenses. The fund's expense ratio covers these.

Let's consider two fictional mutual funds, Fund A and Fund B. Both funds start the year with an asset value of $100,000 and generate a gross return of 7 percent over the year. Fund A has an expense ratio of 0.50 percent, and Fund B has an expense ratio of 1.50 percent.

At the end of the year, Fund A's net asset value would be:

$100,000 + ($100,000 * 7%) - ($100,000 * 0.50%) = $106,500

For Fund B, the calculation would be:

$100,000 + ($100,000 * 7%) - ($100,000 * 1.50%) = $105,500

Even though both funds had the same gross return, Fund B's higher expense ratio resulted in a lower net return for its investors. Over many years, this difference can compound, leading to significantly different outcomes for investors in Fund A versus Fund B.

Understanding expense ratios can thus be crucial in choosing between different mutual funds.

Expense Ratios in Exchange-Traded Funds (ETFs)

ETFs are similar to mutual funds in that they represent a pool of assets. However, unlike mutual funds, ETFs are traded on an exchange like individual stocks. This gives them added flexibility in terms of when they can be bought and sold. But like mutual funds, ETFs also come with costs, and these are expressed through the expense ratio.

Expense ratios in ETFs function just like those in mutual funds. Once again, the expense ratio represents the total annual cost to operate and manage the ETF, and they are deducted from the fund's assets. Thus they effectively reduce the fund's returns and, subsequently, the returns to you as an investor.

However, ETFs often tend to have lower expense ratios than mutual funds. This is primarily due to their passive management style. As such, they require less active management, which can lead to lower costs.

Here is an example. Let's consider ETF X with an expense ratio of 0.10 percent and ETF Y with an expense ratio of 0.40 percent. Suppose you invest $10,000 in each of these fictional funds, and they both generate a gross return of 8 percent over the year.

At the end of the year, your investment in ETF X would be:

$10,000 + ($10,000 * 8%) - ($10,000 * 0.10%) = $10,790

Your investment in ETF Y would be:

$10,000 + ($10,000 * 8%) - ($10,000 * 0.40%) = $10,760

Though both ETFs generated the same gross return, the higher expense ratio of ETF Y resulted in a smaller net return for you as an investor.

These differences might seem small over a single year, but they can compound significantly over the long term.

The Difference Between Passively and Actively Managed Funds

Let's take a little diversion here. We just mentioned passive and active management. Generally, mutual funds are usually managed actively, while ETFs are very often passively managed —think index funds.

So it is probably worth digging into those terms a little.

Passively Managed Funds

Passively managed funds, as the name suggests, are not actively overseen by a fund manager making regular investment decisions. Instead, they are designed to mirror the performance of a specific market index, like the S&P 500. They hold the same securities in the same proportions as the index they track.

As such, they generally have lower expense ratios. This is because they require less active management and less frequent trading, which translates to lower operating costs.

Actively Managed Funds

On the other end of the spectrum are actively managed funds. These funds are overseen by a fund manager or a team of managers who use their expertise to pick and choose securities with the aim of outperforming the market.

As you might expect, actively managed funds usually have higher expense ratios due to the increased research and trading costs associated with the active management strategy. Expense ratios for these funds can range widely but can be as high as 1.5 percent or more.

Knowing Helps You Invest

Now it is time to put it all together. The expense ratio will help you compare mutual funds and ETFs when you make an investment decision.

Here is the bottom line, the expense ratio is an often overlooked yet crucial factor that can significantly impact your returns from mutual funds and ETFs.

This ratio measures the costs to operate a mutual fund or an ETF, which are then deducted from the fund's assets, effectively reducing the returns to investors. While it may seem like a small percentage, its long-term impact can mean the difference between a comfortable retirement and one filled with financial anxieties.

It's not enough to focus solely on a fund's past performance; understanding the cost of investing, represented by the expense ratio, is key to making smart investment choices.

Remember, whether the fund is passively or actively managed can also influence the expense ratio, often making ETFs a more cost-effective choice due to their passive management style.

By understanding the significance of expense ratios and considering them in your investment decisions, you will be more likely to make informed choices that align with your long-term financial goals.