When you purchase a mutual fund, the fund buys and sells underlying investments on your behalf, incurring costs for the fund. The fund passes some of these costs onto you in the form of an expense ratio. Learn more about this cost to help you maximize the returns of your mutual fund.
What is the mutual fund expense ratio?
The mutual fund expense ratio measures the operating costs of the fund as a percentage of the fund’s average net assets. You will often see it expressed as a percentage of the fund’s assets that are taken out of the fund each year to cover its costs.
You may also see expense ratios expressed in units known as “basis points.” One basis point equals 0.01%. Here are some examples you can use as a guide for interpreting expense ratios:
- A fund with an expense ratio of 0.20% costs you the equivalent of 0.002 of the amount you invested.
- A fund with an annual expense ratio of 1.10% costs 0.011 of your total assets in the fund.
- A fund charging 30 basis points costs 0.30% or 0.003 of the amount you invested annually.
Expense ratio fees are not deducted from your account. Instead, they are taken out of the fund’s total assets before you receive your share. Suppose the investments held by a mutual fund generate an annual return of 10%. If the fund has an expense ratio of 1%, your actual return, after fees, is 9%.
Expense ratios represent a cost to shareholders of holding a mutual fund. The lower the expense ratio, the better. You will receive more of the fund’s returns each year. The result is a higher investment value at the end of the investment period.
Average expense ratios
The operating costs of mutual funds depend on the level of management required for the fund and the securities being invested in. According to mutual fund research firm “Morningstar,” the average expense ratio for mutual funds and exchange-traded funds in 2019 was 0.45%.
Mutual funds may follow an active or passive management philosophy. Actively managed funds spend money on research and trading. They try to select the best set of investments within the category they focus on. Due to the additional work required, they have higher costs.
In contrast, passive funds have a predefined set of investments. They have much lower costs. “Morningstar” found that actively managed funds had a higher average expense ratio of 0.66%. Funds managed passively had an average expense ratio of 0.13% less.
Funds that hold international investments tend to have higher expense ratios than funds that hold large U.S. companies because it requires more expertise and research to trade in foreign investments.
When comparing expense ratios, it’s best to compare funds holding similar types of investments. Comparing the expense ratio of an emerging markets fund to the expense ratio of a large-cap U.S. stock fund won’t be useful. However, it will make sense to compare the expense ratios of two emerging markets funds.
Don’t fall into the illusion that funds with higher expense ratios perform better over time than those with lower costs. The truth is that low-cost passive funds often outperform high-cost active funds.
Finding a mutual fund’s expense ratio
While looking at average expense ratios can be helpful, the only way to get an accurate account of the operating expenses related to a fund is to research it. There are three ways to find the expense ratio of any mutual fund:
- Find
- Find it on the brokerage firm’s website
- Search for it using the fund’s code
- Locate it in the fund’s prospectus
Some fund prospectuses contain two cost ratios: total expense ratio and net expense ratio. The total expense ratio represents all costs associated with the fund, relative to the fund’s average assets, including operating costs, interest expenses, and other management fees. The net expense ratio represents the fees charged after waiving certain charges and reimbursements. In other words, the net expense ratio is what you actually pay to carry the fund.
Calculating Expense Ratio Fees
You will not pay the fees from the expense ratio directly. Calculating how much of your investment will be consumed by operating costs each year will help you choose mutual funds that will enhance your returns over time.
To calculate the expense ratio fees, multiply the expense ratio as a decimal by your investment amount. For example, if you choose a fund with an expense ratio of 0.65%, you will pay $65 annually in fees for every $10,000 you invest in the fund.
If you choose a fund with an expense ratio of 0.15%, you would only pay $15 for every $10,000 you invest in the fund. Choosing a fund with lower fees could save you $50 for every $10,000 you invest. While such savings may seem small relative to the total value of your portfolio, they can accumulate over a long period.
Conclusion
Many investors pay a lot of money in their investments without even knowing it. The fees resulting from expense ratios represent a cost to shareholders that reduces their return on investment. For this reason, an investor looking to maximize their returns should seek out mutual funds with expense ratios lower than the average. For example, if you can find a mutual fund with an expense ratio that is about 0.50% lower than what you are currently paying, on $100,000 you would save about $500 annually. Over 10 years, you would achieve $5,000 in savings.
You should also keep in mind that operating costs are not the only fees that can impact your returns. When comparing mutual funds, also consider how any taxes imposed when withdrawing funds affect your investment return. This way, you can gain a better idea of the actual return of any mutual fund in the market.
Frequently Asked Questions
How are expense ratios charged?
Mutual fund expense ratios are typically charged by deducting a portion of the earnings generated from distributions and capital gains. Some funds may have more distributions from capital gains or vice versa. Wherever the fund’s profits come from, that’s where the fees are deducted. If there are no profits, the fees will be deducted from the assets.
What are the average expense ratios for a money market fund?
Money market funds have expense ratios similar to those imposed by passive funds. Most fund fees will be good enough, with some being less than 0.2%. You can use a mutual fund screener tool to sort your broker’s money market options by expense ratios.
Source: https://www.thebalancemoney.com/expense-ratios-paying-much-2388663
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