A Guide to Expense Ratio in ETFs and Mutual Funds

Key Takeaways 

• Represented as a percentage, the expense ratio is the overall fee paid by investors for a fund’s management. 

• The expense ratio includes all management, marketing, and administrative fees.

• Usually, the average for passively managed ETFs and mutual funds is between 0.03% and 0.3%.

Often overlooked, fees associated with exchange-traded funds (ETFs) and mutual funds can significantly impact investment outcomes and are crucial for investors to understand. These fees, part of how these funds operate, are called expense ratios.

With knowledge and the right tools, though, investors can take positions that align with their financial goals while keeping costs low. 

Expense Ratio Explained 

Before using ETFs or mutual funds for portfolio diversification, retirement, or other financial goals, an understanding of expense ratio is in order. Represented as a percentage, the expense ratio is the overall fee paid by investors for a fund’s management. It includes all management, marketing, and administrative fees.

If we use a more technical language, the Expense Ratio is the total annual cost of owning a fund (EFT, mutual fund, or index fund). It is expressed as a percentage of the assets under management (AUM). The Expense Ratio includes:

• Management fees: paid to the fund manager or investment firm managing the portfolio of assets. These fees are also known as MER (Management Expense Ratio).
• Administrative fees: for operations like customer service, recordkeeping, etc.
• Marketing and distribution fees (sometimes called 12b-1 fees): these fees are common in mutual funds, and not EFTS.
• Other operating expenses: custodial services, legal, audit, etc.

In other words, Expense Ratio = MER + admin, marketing, other fees.

For example, say an expense ratio is 0.2%. So, every $1,000 invested in a fund requires $2 in yearly operating expenses. The fees are derived from the investor’s returns over time, so they are unavoidable. And they can make a big difference as returns are subject to compound interest. They represent the proportion of an individual’s total investment that is deducted each year.

Example:

Consider a $5,000 annual investment with a steady 7% annual rate of return.

Had the investment been in a fund with a 0.3% expense ratio rather than a 0.6% expense ratio, net earnings after 30 years would have totaled $477,548.88 instead of $451,415.35.

What is a Good Expense Ratio?

So, just what is a sought-after ratio? There is no hard-and-fast rule and it varies among funds. But according to most insights, the expense ratio should be under 1% to 1.5%. Ratios over that are generally considered high. A good ratio is generally viewed as one between 0.5% and 0.75%, balancing cost and value.

Note that, because portfolios of actively managed funds must be managed in real time, those funds usually have greater expense ratios than passively managed funds. With the latter, an index or sector is simply tracked.

Expense Ratios in ETFs

In practical terms, many investors consider the expense ratio the price they pay to a fund manager to research securities and make selections for them. 

Operational costs typically cover costs related to administration, distribution, compliance, and management. They also typically go toward marketing, record keeping, and shareholder services. Such costs can vary markedly depending on the fund’s size, the investment strategy, and investment category.

Usually, the average for passively managed ETFs and mutual funds is between 0.03% and 0.3%. Meanwhile, for actively managed funds, the average is between 0.5% and 1%. 

Note that there may be additional fees with mutual funds such as front and back-end loads. Before investing, it is essential to thoroughly understand a fee’s structure, as it can greatly impact long-term investment outcomes.

High Expense Ratios

The lower the expense ratio, the better, since an expense ratio lowers returns. When considering funds and costs, it is best to compare funds that own similar investment types. 

A fund’s expense ratio can be determined by researching:

• The fund’s prospectus. This is sent to shareholders annually, but it can also be found on the fund company’s website. Typically, the expense ratio is found under “shareholder fees.”
• Fund screeners. Many screeners are available digitally and can be used to compare ratios across comparable investments. They may be searched by group or category. The tool can estimate the effect of expenses and fees on the investment.
• Financial news sites. Yahoo! Finance, Google Finance and similar websites carry expense ratio data for ETFs and mutual funds.
• News Journals. Business-heavy print newspapers such as The Wall Street Journal and Investor’s Business Daily for expense ratios and other information about funds.

Calculating Expense Ratios

The expense ratio formula is:

Expense ratios = the fund’s net operating expenses/ the fund’s net assets

To calculate the ratio, locate the fund’s total operating expenses, which can generally be found in the fund’s shareholder report. The report should also contain the fund’s average assets for the year. Next, divide the total operating expenses by the fund’s average assets. Finally, multiply the result by 100 for the expense ratio.

Thankfully, an ETF expense ratio calculator may be used to calculate the amount of money an investor will have at the conclusion of an investing period. It will also indicate how much of that total will go toward fees.

There are also mutual fund calculators that, by inputting some prospectus information, can help assess the costs associated with purchasing mutual fund shares. Inputs include investment amount, return rate, and holding period. It also factors in sales charges, deferred sales charges, and other fees and commissions.

The tool is somewhat similar in usefulness to the Sharpe ratio, which gauges an investment’s performance after adjusting for risk. Other tools include the turnover ratio, which assesses a company’s effectiveness in extending credit and collecting debts. The price-earnings ratio, meanwhile, is the ratio of a company’s share price to the organization’s earnings per share,

Fees, Returns, and Your Investment 

Because expense ratios can erode investment earnings, it is vital to understand what they are and their potential impact on an investment portfolio. Even a minute difference in paid fees can make a difference over time.

For example, if $10,000 was invested in a fund that has a 2.5% expense ratio, the fund’s value after 20 years would be $51,524. If the investment had gone into a lower expense ratio, say one at 0.5%, the investment after two decades would be worth $64,122.

Before investing, consider a fund’s sales charges, age and size, and taxes. Also factor in risks and volatility, its impact on portfolio diversification, and any recent operations changes.

Note that funds with greater internal costs usually shift those costs to shareholders via the expense ratio. For example, a fund with small assets may have a relatively high expense ratio. Why? Because the fund’s asset base for expenses is restricted.

Pros and Cons of Investing in ETFs and Mutual Funds

Compared to open-end funds, exchange-traded funds can provide lower operating costs as well as increased transparency, flexible trading, and improved tax favorability in taxable accounts.

Mutual funds have advantages as well. They offer professional management, liquidity, and diversification. Other benefits can include reduced costs, affordability, transparency, and tax benefits.

Mutual funds generally have higher expense ratios than ETFs, largely due to structural differences. Mutual funds tend to charge a mix of transparent costs and those that are not so apparent. While ETFs can also have hidden fees, they do not have as many, and they generally cost less.

Generally, ETFs provide more trading flexibility and transparency than mutual funds and are more tax efficient.

Diversification and Risk Reduction

Both ETFs and mutual funds contribute to diversification. Through ETFs, investors have access to a broad range of asset classes such as stocks, bonds, and other commodities. They offer high transparency and the liquidity of traditional stocks.

Because mutual funds invest across a myriad of individual stocks, bonds, or other securities, they offer instant diversification. What is more, history has shown that expansive groups of stocks tend to generally do better with market volatility than do individual stocks.

As a financial strategy, portfolio diversification is crucial. It seeks to mitigate portfolio risk by varying the asset types invested, understanding that they will perform differently over time. Diversification can also protect against inflation and improve returns.

Alternative assets are increasingly popular as a means of diversification, as they are tied to private markets. Due to their low correlation to intrinsically volatile public markets, they are generally more stable. Further, private markets have outperformed the stock market in every economic downturn of the last 15 years. The aim is to help grow and protect wealth.

Alternative Investments and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, platforms like Willow Wealth provide curated access to private markets for individual investors.   

Investors can get started with minimum investments as low as $5,000 for their first investment (subject to certain exceptions). Willow Wealth offers a curated selection of opportunities across multiple asset classes, ranging from individual investments to diversified funds and automated portfolio solutions. While these investments carry risk, they open the door to opportunities across real estate, private credit, private equity, and more.  

Join more than 500,000 members and start investing in private markets today at willowwealth.com.

In Summary

Those ETF and mutual fund fees can really eat away at investment earnings. By comparing expense ratios, strategizing to minimize fees, and exploring the balance between cost and investment value, investors can be empowered to make more informed decisions.