There are a handful of financial terms out there that every investor -- regardless of their level of involvement or portfolio size -- should know inside and out.
The expense ratio is one of those essential terms. You have to know what it means, where to look for it, and what you should reasonably expect it to be -- at least if you want to invest intelligently.
So, what is an expense ratio? And why is it so important? Here's the brass tacks:
Expense Ratio Basics
Investing isn't free, and neither is having other people invest for you.
If you've ever bought or sold a stock and paid a commission, or used a financial advisor that charged you a percentage of assets under management (AUM), you understand this well.
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Stocks don't have expense ratios, but funds do: mutual funds, exchange-traded funds (ETFs) and index funds. Analogous to the percentage of AUM that financial advisors charge clients, the expense ratio is the percentage of assets deducted each year to pay for fund expenses.
When shareholders pay the expense ratio they're covering management and administrative fees, operating costs, and advertising and promotion expenses like the 12b-1 fee, if there is one.
"When you see an ad for a mutual fund on TV, fees charged as part of the expense ratio actually helped pay for it," says Caleb Silver, editor in chief of Investopedia.
So in simple terms, the expense ratio represents a fund's expenses divided by the fund's assets.
Why Is the Expense Ratio Important?
"The expense ratio is extremely important to investors because it's one of the few variables that investors can actually control," says Ryan Repko, financial planner at Ruedi Wealth Management.
"There's an inverse relationship between your investment performance and your funds' expense ratios: The higher the expense ratio, the lower your return; the lower the expense ratio, the higher your return," Repko says.
That much makes sense, but what isn't so intuitive is how even modest differences in the expense ratio can mean life-changing differences in the value of your portfolio over the long-run.
The deleterious effect of higher expense ratios is best illustrated in a hypothetical example -- one that's all too real for many retirees.
Expense Ratio Example
Consider two large-cap stock market funds that track the same universe of stocks. Fund A has an expense ratio of 0.8%, while Fund B has an expense ratio of 0.2%. They're both no-load funds, meaning neither charges sales charges known as front-end or back-end loads.
Suppose you invest $10,000 in Fund A, which earns a 10% annualized return for 30 years.
At the same time, your neighbor Frank invests $10,000 in Fund B. That fund also earns a 10% annualized return for 30 years.
Your investment will have turned into $137,129. You'd have paid $37,364 in the form of fees and foregone earnings over 30 years.
Frank, on the other hand, would have $164,322, and would've paid $10,171 just in expenses and opportunity costs.
"Every penny not spent on the expense of your funds stays within your account, earns interest, and compounds time and time again," Repko says. And if you thought the compounding you missed out on over 30 years was depressing, wait till you see how your neighbor Frank is living in another 20.
Assuming the same fees and returns, your $10,000 in Fund A turns to $785,630 over 50 years, while the $10,000 in Fund B becomes $1,062,089. Frank's new Bentley starts to make a bit more sense in this context.
So What's a Good Expense Ratio?
The benefits of a lower expense ratio should now be clear, but what sort of expense ratios are actually offered by mutual funds, ETFs and index funds? And how do you know what's fair and what isn't?
First off, actively managed funds -- funds with hands-on managers seeking to beat the market by buying and selling opportunistically -- will have higher expense ratios than passively managed funds simply seeking to replicate an index or benchmark.
Active funds have to spend more on analysts and research tools to find bargain-bin stocks to buy (and to know when to sell).
A good expense ratio today is different than it was 20 years ago. In 2000, the asset-weighted average expense ratio for actively managed U.S. open-end mutual funds and ETFs was just above 1%. As of 2017, it was 0.73%.
The average expense ratio for passive U.S. stock market funds has also been slipping, falling from about 0.26% in 2000 to 0.11% in 2017. To put that in perspective, that's $11 a year for every $10,000 invested.
There are so many low-cost index funds, ETFs and mutual funds nowadays that there's almost no excuse for owning funds charging anything in the neighborhood of 1%.
"Ideally you should pick a fund that aligns with your investment time horizon that has the lowest expense ratio," Repko says.
Another Reason the Expense Ratio Is Important
Studies have long shown that the vast majority of actively managed funds charging higher fees for their expert stock picking and market timing abilities have failed to make up for those fees by earning higher returns.
And while funds focused on international stocks and alternative investments can have higher expenses, ditch funds charging more than 0.5% unless they have a compelling reason to do so.
Investors have caught on to the large scale, long term and costly underperformance of active funds, rotating incredible sums of money into passive, low-fee investments like index funds. In 2017, funds in the lowest quintile (20%) for fees in their Morningstar category group saw net inflows of $949 billion. The remaining 80% of funds saw outflows of $251 billion.
The demand has sparked competition among fund families to offer lower and lower fees, saving investors a fortune over time.
Look to your 401(k) and make sure you've got a wide selection of funds with low expense ratios to choose from -- it can make a big difference in retirement.
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