Why All Investors Need to Understand Expense Ratios

New investors figuring out how to invest money can get overwhelmed by all the new terms they come across. You may be learning what a portfolio or a position is. Or maybe you’ve just figured out how to set up automatic recurring investments for the first time. Regardless of where you are in your investing journey, it’s to your advantage to learn certain concepts early on to avoid costly mistakes.

You may have asked yourself, “What is an expense ratio?” after coming across the term in a fund’s prospectus or on a brokerage firm’s website. Learning how mutual fund expense ratios work and how they impact your investments can affect the long-term returns those investments provide. And once you understand what they are, it may become an important part of how you choose where to invest.

Here’s what you need to know about expense ratios so you make the best investment decisions for you.

What is an expense ratio?

Expense ratios show you an investment’s costs over a year as a percentage of its assets. Expense ratios are most commonly seen on mutual fund and ETF (exchange-traded fund) investments. It’s easiest to explain by looking at the formula used to calculate an expense ratio.

Expense ratio = Total annual fund operating expenses / Average net assets of a fund

Total annual operating expenses of a fund can include many items you may never even have known existed. Managing a mutual fund or ETF requires paying people, administrative costs, costs to market the fund like 12B-1 fees, distribution fees, portfolio management costs, and other operating costs.

An expense ratio doesn’t include all the fees you pay on your investments, though. It only consists of the fund’s expenses. For this reason, commissions charged on trades you make to buy and sell a fund aren’t included in the expense ratio.

The average net assets of a fund are the value of the fund’s holdings on average throughout the year. For example, an S&P 500 index fund’s assets would include the stocks held within the fund.

Net expense ratio vs. gross expense ratio

Investments can have more than one type of expense ratio. In some cases, the fund may have a different gross expense ratio than its net expense ratio. The differences can seem mysterious, but the net expense ratio is what matters to you right now.

A gross expense ratio includes the total costs of managing the fund without including any fee waivers or reimbursements to the fund. A net expense ratio is what the fund company actually pays after accounting for these fee waivers and reimbursements.

But why do reimbursements and fee waivers exist? When a fund is new, the managers may try to lower the mutual fund’s expense ratio to encourage investing in the fund. They do this by offering waivers or reimbursements.

If a gross expense ratio is significantly higher than a net expense ratio, you must consider whether the waivers and reimbursements the fund receives can continue indefinitely. If not, your net expense ratio could increase once the fund manager has achieved the growth they desired.

Why expense ratios matter

Expense ratios may not seem important to your investment strategy in the short term. A 1% expense ratio results in roughly a $10 cost over a year if you hold $1,000 of an investment. Looking at it another way, a fund with 8% returns over a year and a 1% expense ratio still leaves you 7% ahead, right?

But expense ratios make a huge difference when you change your viewpoint to look at their long-term impact. Over time, all these administrative fees have a compounding effect. Each year you pay a fee results in less of your money left invested to earn future returns. When this happens every year, even a .50% difference in expense ratios can make a huge difference in the ending balance of your total assets.

An example drives the point home. Let’s say two people are both 25 years old and plan to invest $500 per month until they turn 65. That’s 40 years of consistently investing. They invest in investments with identical 8% annual returns before factoring in the expense ratios. Person A’s investment has a 1% expense ratio, but person B’s investment only has a .5% expense ratio.

At the end of the 40 years, person A’s ending investment balance is $1,312,406. Person B’s ending investment balance is higher due to the lower expense ratio. Person B ends up with $1,511,910 — a staggering $199,504 more than person A.

If person A had done the extra work to find the investment with the lower expense ratio — something that would have only taken a few minutes — they could have been almost $200,000 wealthier at retirement.

When you’re figuring out how to choose a brokerage firm, it’s imperative to look at your investment options and their expense ratios. Some brokerage firms have expense ratios that tend to be higher or lower than other brokerage firms. If both firms offer investment options with similar returns, the low-cost firm may be the better option for you.

Investments that tend to have low expense ratios

Some investments tend to have lower expense ratios than other investments. This makes sense when you think about how they work. To understand this, you’ll want to be familiar with the concept of active vs. passive investing. Passive investments don’t require as much work to maintain, so they often have lower fees. More active investments incur more costs to enact their strategies.

An index fund aims to mimic the returns of a specific index, such as the S&P 500. All a fund manager has to do is make sure their investment holdings match the makeup of the S&P 500. They don’t have to do any research or look for unique investment opportunities. Therefore, the fund doesn’t need a highly paid fund manager with unique insights or trading strategies that add to its costs. The investment manager will have to make trades as the composition of the index changes, but those changes aren’t typically frequent, so trading costs are often lower. For these reasons, index mutual funds and ETFs normally have lower expense ratios.

On the flip side, actively managed mutual funds exist to beat the market and provide outsized returns. The fund manager could have a massive impact on those returns, so some investment companies pay managers large salaries or bonuses to attract the best talent. These managers need access to analysts, research, other data, and systems to eke out any extra gains they can. This all comes at a cost.

Finally, these funds must try to beat the market by buying and selling investments at the correct time to maximize profits. Each time a fund buys or sells a security, the extra costs could increase the expense ratio. These costs usually result in actively managed mutual funds and ETFs having higher expense ratios.

Not all investments have expense ratios, though. If you buy a share of an individual company, you’re the one managing your assets. You may have to pay a trade commission or a monthly maintenance fee to your brokerage, but there is no expense ratio on your investment.

If you build your own portfolio of stocks, you can avoid expense ratios altogether. This requires a much more active management approach, though. Many investors don’t have the time or desire to implement this strategy.

FAQs about expense ratios

Bottom line

Expense ratios of the investments you choose can have a considerable impact on your future investment returns and considering them should be part of your decision process when choosing investments. Although expense ratios aren’t the only aspect of an investment to consider, you should always know the expense ratio before investing.

Two similar investments may have virtually identical returns but very different costs. In these cases, making an informed decision can help you grow your wealth and have a better chance of succeeding in the stock market. Choosing the investment option with a lower expense ratio may result in a larger investment balance down the road if all else is equal.