How Mutual Fund Expense Ratios Work
Learn how expense ratios can affect the return on your investments
When you buy a mutual fund, the fund is buying and selling the underlying investments for you. They incur expenses in the course of performing this service, and they pass along a portion of these expenses to people who invest in the fund through a cost known as an expense ratio. Understanding this cost can help you maximize your mutual fund returns.
Basics of Mutual Fund Expense Ratios
An expense ratio measures the operational costs of a mutual fund relative to the fund's average net assets. It is usually stated in terms of the percentage of the fund's assets that is taken out of the fund each year to cover its costs.
But you will also see expense ratios expressed in units known as "basis points," where one basis point is equal to .01%. Use these examples as a reference for how to interpret expense ratios:
- A fund that has an expense ratio of .20% costs the equivalent of 0.002 of the amount you have invested.
- A fund with an expense ratio of 1.10% annually costs 0.11 of the total assets you have in the fund.
- A fund that charges 30 basis points charges .30%, or 0.003 of the amount you have invested per year.
Expense ratio fees are not taken from your account or investment. Instead, they are deducted from the total assets of the mutual fund before you get your share. If, for example, the investments owned by your mutual fund deliver an annual return of 10%, but the fund has an expense ratio of 1%, your actual return, less fees, is 9%.
This is why expense ratios represent a cost for shareholders for holding a mutual fund. The lower the expense ratio, the better, because you annually get to keep more of the fund's returns. The result is a higher investment value at the end of the investment holding period.
Average Expense Ratios
Operational expenses for mutual funds depend largely on the level of management required for the fund and the individual securities in which they are invested. But according to the mutual fund research firm Morningstar, mutual funds and exchange-traded funds had an average expense ratio of 0.45% in 2019.
Mutual funds may follow an active or passive management philosophy. Actively managed funds spend money on research and trading trying to pick the best set of investments within the category they focus on, and because of the extra work involved, they have higher expenses. Passive funds, in contrast, own a pre-determined selection of investments and have much lower expenses. Morningstar found that Actively managed funds had a higher average expense ratio of 0.66%, while passively managed funds had a lower expense ratio of 0.13% on average.
In addition, funds that own international investments tend to have higher expense ratios than funds that own large U.S. companies because it takes more expertise and research to trade in overseas investments.
When comparing expense ratios, it is important to compare funds that own similar types of investments. It would not be useful to compare the expense ratio on an emerging-market fund to that of a U.S large-cap fund. It would, however, be appropriate to compare the expense ratio of one emerging-market fund to that of another.
A myth among beginner investors is that funds with higher expense ratios perform better over time than low-cost funds. The truth is that passive funds with lower fees often outperform active funds with higher fees.
Finding a Mutual Fund’s Expense Ratio
Although looking at average expense ratios can be helpful, the only way to get an accurate account of the operational expenses associated with a fund you want to invest in is to look it up. There are three ways to find out the expense ratio of any mutual fund.
Locate it on the brokerage company website. For example, let's say you want to find out the expense ratio of Vanguard 500 Index Fund Admiral Shares. Visit Vanguard's website for personal investors. In the search box at the top of the page, start typing the fund name. The relevant fund should appear in the results. Clicking the result takes you to a page with a fund summary, which notes the expense ratio (0.04%).
Look it up using the fund's ticker symbol. A mutual fund's ticker symbol is a series of five letters. For example, Vanguard 500 Index Fund Admiral Shares has a ticker symbol of VFIAX. If you search for the symbol on google.com, you should see a market summary at the top of the search results page with the fund's expense ratio.
Find it in the fund’s prospectus. This brochure that provides information about the fund is mailed or emailed to investors each year. You can download a fund’s prospectus from the mutual fund company’s website. Look in the table of contents for a section relating to fees and expenses to learn the expense ratio of the fund.
Some fund prospectuses include two expense ratios: a gross expense ratio and a net expense ratio. The gross expense ratio amounts to all expenses associated with a fund, including operating expenses, interest expenses, and other management fees, relative to the fund's assets. The net expense ratio represents fees collected after fee waivers and reimbursements. In other words, the net expense ratio is what you actually pay to hold a fund.
Figuring Expense Ratio Fees
Although you don't directly pay the fee incurred from an expense ratio, figuring out how much of your investment would be eaten by operational expenses every year helps you pick mutual funds that will increase your returns over time.
To calculate expense ratio fees, multiply the expense ratio as a decimal by the value of your investment. For example, if you select a fund with an expense ratio of 0.65%, you will annually be charged $65 in fees for every $10,000 you invest in the fund.
If you pick a fund with a 0.15% expense ratio, you will only pay the equivalent of $15 for every $10,000 you invest in the fund. Choosing the lower-fee fund can save you $50 per $10,000 invested. While such savings may seem minuscule relative to the total value of your portfolio, they can add up over a long investment holding period.
The Bottom Line
Unknowingly, many investors pay too much for their investments. Fees arising from expense ratios represent a cost to shareholders that has the effect of reducing the return on your investment.
For this reason, the investor who wants to maximize his returns should seek out mutual funds with below-average expense ratios. For example, if you can find a quality mutual fund with an expense ratio that is about 0.50% less than what you currently pay, on $100,000 that saves about $500 a year. Over 10 years, you would reap $5,000 in savings.
Keep in mind that operational expenses aren't the only fee that can eat into your returns. When comparing mutual funds, also consider how any taxes imposed at the time of withdrawal would affect your return on investment. This way, you can get a sense of the real return of any mutual fund on the market.