If you’ve been investing for a while, you’ve probably heard of an “expense ratio.” This is a decimal number on the fact sheet of an investment fund that isn’t always explained. But even if you know what it means, you might not know how it affects your money.
The question now is, what is an expense ratio?
As the name suggests, an expense ratio is about the costs of running a fund. These costs include everything from management and marketing to accounting and administrative costs. (A fund is just a group of money set aside for a certain purpose. In this case, the money comes from different investors and is usually put into a fund manager’s basket of stocks or bonds.) Costs for funds are usually charged as a percentage of the money you put into them.
An actively managed fund manager may buy or sell shares every day to increase returns. But even passive index funds, which usually use a “buy and hold” strategy and often follow a benchmark index similar to the S&P-500 index stock, have some costs. This is because they still need to be maintained regularly, like when investors add or remove money or when the fund’s index reevaluates its holdings.
A ratio or percentage can be hard to understand, so it may help to think of it as the cost for every $1,000 invested. With an expense ratio of 1%, $10 of every $1,000 you invest each year covers fund costs.
What is the purpose of a cost-benefit analysis?
Expense ratios are calculated as a percentage of the average daily returns and are included in a fund’s performance data. That means that if your fund is up 10% and your expense ratio is 1%, you’ll only see a return of 9%.
How much do expenses cost on average?
Since index funds came out, expense ratios have been going down pretty consistently. Morningstar’s 2018 fee study says that the average expense ratio is now.48%. That’s about $5 for every $1,000 that was put in.
But that average doesn’t tell the whole story because it includes actively and passively managed funds.
Average expense ratios for “active” funds, constantly managed and curated by investment professionals, are closer to.67% ($6.70 per $1,000). Passive funds, which try to match the performance of major indexes, have a lower expense ratio.15% ($1.50 per $1,000 invested). That means that fees for active funds are more than four times higher than fees for passive funds.
The average expense ratio for stock-based index funds, like an S&P 500 fund, is even lower than that of other passive funds, at 0.09 percent, according to the Investment Company Institute (ICI).
Even though $5 a year for every $1,000 seems like not much, it can add up over time. Assuming a reasonable rate of return of 7.5% and a $100 monthly investment, the average actively managed fund will cost over $10,000 more over 30 years than the average passively managed fund. And as more money is put into investments, the gap only gets bigger.
If you invest $1,000 a month for 30 years, the difference in fees is more than $100,000.
The difference in fees doesn’t mean that you should never invest in actively managed funds. If they always do better than the passive funds, you could have more money in the long run. But it’s not a given that they will.
Do actively managed funds do better?
Even the experts have difficulty consistently beating the market (and, by extension, for active funds to outperform passive funds). In 2018, the performance of 64 percent of active funds was worse than their S&P 500-stock index benchmark for that year, and things only get worse when you look back further.
S&P Dow Jones Indices says that when you look at the average annual performance of actively managed funds over the past 15 years, nearly 92% fall short of their benchmark.
This means that some actively managed funds may do better than their benchmarks (and the index funds similar to them) in the short term. Still, less than 10 percent do so in the long term. Even though it’s possible to pick an actively managed fund that consistently does better than its benchmark, the odds aren’t in the average investor’s favour and worsen every year.
This is why it’s important to know about expense ratios. By keeping these fees as low as possible, you can put more of your money to work for you instead of paying for the funds to run.
How do I find out a fund’s expense ratio?
Check the fund’s prospectus or fact sheet to determine how much it costs to run. You can also find the expense ratio of your funds quickly on sites like Morningstar, Kiplinger, and the Securities and Exchange Commission.
How do I find inexpensive funds?
Once you’ve chosen passive funds with low expense ratios, you have a couple of options. You can research individual funds and then buy shares through a brokerage or use an investment scheme like Acorns, which makes it easy to invest in a diverse portfolio of very low-cost marketplace funds (ETFs) with exposure to thousands of stocks and bonds.