What Is an Expense Ratio?
Managed funds take a good amount of oversight to run. That’s a large part of their appeal – there’s a professional team at the helm to make sound investment decisions. To keep these funds running smoothly and outperforming the market, they need to pay the decision-makers who run them. This payment takes the form of an expense ratio.
An expense ratio is a measure of the total fees and costs associated with buying investment funds. Every single person who buys into the fund pays that fund’s expense ratio. Whatever the percentage is, it represents the amount of your investment that goes toward the operations and management of the fund.
The expense ratio of a well-managed fund will pay for itself in returns that far exceed the average market return. However, a poorly managed fund with a high expense ratio could cause investors to struggle to break even on their investment. Here’s what you need to know if you’re investing in a fund that carries an expense ratio.
What Costs Does an Expense Ratio Cover?
An expense ratio is an annual fee, paid by investors as a contribution to the management of the fund. It covers all the major operational expenses required to ensure the continued performance of the fund. Some of the major costs the expense ratio covers include…
- The cost of marketing and advertising the fund (12b-1 fees)
- General fund management (buying, selling)
- Research and investigation of new opportunities
- Rebalancing and weighting of the fund
- Physical office space to house the management team
- Salaries for fund managers and office staff
- Financial document and tax preparation services.
An expense ratio is separate from sales commissions and loads. Instead, these latter two fees are front- and back-end charges that come into play only when investors buy into or sell out of a fund.
How Much Is an Expense Ratio?
- Schwab 1000 Index ETF (SCHK) is a large-cap fund with a ratio of 0.05%.
- High Yield ETF (HYLD) is a high-yield bond fund with a ratio of 1.29%.
- ProShares Global Listed Private Equity ETF (PEX) carries a ratio of 3.41%.
- VanEck Vectors BDC Income ETF (BIZD) has a staggering ratio of 10.23%.
Generally, the lower the expense ratio, the more efficient the fund is – since an expense ratio covers the operational costs associated with managing it. Many funds keep expense ratios low by relying on intelligent trading software.
Expense ratios are also high for more complicated funds. The Schwab 1000 Index ETF (SCHK), for example, requires little to no management on a daily basis because it paces broader indexes. Meanwhile, the ProShares Global Listed Private Equity ETF (PEX) requires more turnkey management to ensure its carefully cultivated portfolio continues to generate strong returns.
The bottom line is that the expense ratio is the amount you’ll pay to the fund based on your total investment. For example, if you invest $50,000 in a mutual fund with a 1% expense ratio, you’ll pay $500 annually. Often, it’s a small price to pay for market-beating fund performance.
What’s the Average?
Looking for a general average when it comes to expense ratio? It can vary depending on the type of fund you’re looking at:
- Simple mutual funds tend to be higher, averaging 1.1%.
- Asset-weighted mutual funds hover right around 0.5%.
- Simple ETFs charge an average expense ratio of 0.4%.
- Asset-weighted ETFs carry almost no expense ratio.
Keep in mind that these are just average benchmarks for different types of funds. As mentioned, the work that goes into the fund and the fund’s composition can play significant roles in how much oversight it takes to manage and what a justifiable expense ratio is.
Expense Ratio Considerations
While most competitive funds maintain relatively low expense ratios, it’s still important to consider the cost of those fees over the life of an investment. For example, if you deposit $50,000 into a fund with a 1% expense ratio and earn 10% annually over 10 years, you’d end up paying more than $11,300 in fees! Even though you’d effectively double your money on this investment, those management fees are difficult to swallow.
An expense ratio can be even more of a burden for smaller investments and can stunt your accumulation in the early years of growth. Smaller principal balances rely on the power of compounding to kick-start growth. Fees can hamper accumulation early on and leave your investment struggling to ramp up at the same rate as a similar investment, such as indexing.
Finally, look at the performance you’re paying for. If a fund charges an expense ratio in excess of 0.75% or 1%, make sure it has the market-beating returns to justify this expense. Do the math to figure out how much your investment would have earned over the past one, five or 10 years, then figure out the cost. There should be a clear cost benefit to paying the expense ratio. If there isn’t, your investment might end up stalling out in an underperforming fund.
Always Pay Attention to Fees
Fees are the enemy of every investor. In fact, the great Warren Buffett often laments the fees associated with managed funds, once claiming, “Performance comes, performance goes; fees never falter.” And while there’s wisdom to paying attention to fees, there is some credence to paying for performance.
For investors who want to entrust their wealth to a managed fund with proven returns, an expense ratio is a small price to pay for peace of mind. And that’s why it’s so important to learn how to build wealth by making smart investment decisions. To find your investment path to success, sign up for the Liberty Through Wealth e-letter below.