ETF Fees Deducted From Your Investment

Find Out How ETF Fees Are Deducted and How They Affect Performance

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••• How ETF fees are deducted and how they impact long-term performance. Getty Images

ETF fees are low in relation to their investment cousins, mutual funds, but smart investors still do the research and comparisons on expenses before finding the best ETFs for their needs.

The primary reason ETF investors should be aware of the fees before buying is because low expenses are one of the top advantages of ETFs. Since most ETFs track a benchmark index, such as the S&P 500, the best ETFs to buy are often those with the lowest expenses.

The Expense Ratio and How ETF Fees Work

When researching or looking at information on ETFs or mutual funds, one of the most prominent pieces of information you'll see should be what's called the expense ratio.

The expense ratio, expressed as a percentage, is a management fee that is deducted from the fund's assets. For example, an ETF or mutual fund that has an expense ratio of 0.50 percent would deduct half of one percent from the fund's assets on an annual basis. Doing the math for you, an expense ratio of 0.50 percent translates to expenses of $5 for every $1,000 invested.

The ETF fees are deducted to pay for the fund's management and operational costs. The investor will receive the total return of the ETF, less the expenses. For example, if the fund's total return (before expenses) during a year is 10.00 percent, and the expense ratio is 0.50 percent, the net return to the investor (after expenses) would be 9.50 percent. 

Therefore, similar to mutual funds, ETF fees that are included in the expense ratio are not deducted or withdrawn directly from the investor's account; these fees are taken from the fund's assets before they are included in the investors assets (the exact science of the ETF fees process is a bit more complex than this and so the explanation is simplified for educational purposes).

Why ETF Fees Matter

Since the majority of ETFs are passively-managed, their expense ratios tend to much lower compared to most mutual funds. In different words, since ETFs simply track a benchmark index, there is no need for a fund manager to research, analyze, or trade securities and since these activities are eliminated, the cost of operating the fund is dramatically reduced.

The reason that ETFs have become more popular in recent years is the same reason that Vanguard Investments is the biggest mutual fund company in the world: Investors have learned that lower fees translate into higher returns in the long run. Additionally, active managers are human and tend to make mistakes, which contribute to their disadvantage to ETFs and passively-managed mutual funds.

Typical expense ratios for mutual funds will range from about 0.50 percent to 2.00 percent, whereas ETF fees range from as little as 0.05 percent to about 1.00 percent. Therefore the lowest cost ETFs usually have lower expense ratios than the lowest cost index mutual funds.

For example, one of the most widely traded ETFs is the SPDR S&P 500 (SPY), which has an expense ratio of just 0.09 percent. The most popular mutual fund of its kind is Vanguard 500 Index (VFINX), which has an expense ratio of 0.14 percent. Since both funds passively track the S&P 500, an investor highly conscious of fees would hold SPY, which would be expected to have slightly higher returns in the long run (and this slight edge in performance has historically held).

ETF Fees and Choosing the Best Funds

The ETFs that have the lowest fees are not always the best funds to buy. Before buying an ETF, be sure to make apples-to-apples comparisons. For example, be sure that the ETFs you are comparing track the same index. It also helps to look at the performance history and the fund's total assets.

Performance is important because of something called tracking error, which is a measure of an index fund's effectiveness in replicating or "matching" the performance of the benchmark index. If the fund does not closely track the index, the low fees may not compensate enough to make the fund beat a comparable fund. So, be sure to compare historical performance in addition to the expense ratio.

The fund's total assets are important to analyze because larger assets generally mean greater liquidity, which can impact an ETF's performance, especially in the short run. Therefore, ETFs with more assets are generally preferable to those with significantly lower assets.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.