An expense ratio for ETF is an annual fee you pay the issuer to manage your funds actively or passively, including portfolio management fees, operating expenses, transaction costs, marketing costs and more.
Expense ratios are one of the most important things to consider when selecting investments, especially if you’re looking at exchange-traded funds (ETFs).
The expense ratio can vary from as little as .02% to almost 2%, which can enormously impact your return over the years to come. So how do you know what’s a good expense for you?
Expense Ratio – An introduction
Expense ratios can vary widely between different types of funds and even different schemes of the same fund. There are different expense ratios for mutual funds, ETFs and Index Funds tracking S&P 500.
A high expense ratio could cost you significantly and reduce the potential rewards of investing, so it’s important to understand expense ratios before investing.
An Expense Ratio measures the annual costs that an investment company incurs for the management of the fund. It is presented as a percentage of assets under management (AUM) and measures all operating costs, including administrative, marketing and advisory expenses.
A fund’s expense ratio is calculated by dividing the fund’s total fees—management fees and operating costs—by the fund’s total asset value.
The expense ratio is the percentage of your investment the ETF issuer charges to cover the administrative and marketing costs each year. This fee can be as low as .02% or as high as 2%. Essentially, lower expense ratios are better than higher expense ratios. Index funds tend to have low expense ratios because they only invest in securities to match the index they track and do not require much skill and management. The good news is that there are currently zero expense-ratio funds available.
The average expense ratio for actively managed mutual funds hovers between .5% to 1%. On the other hand, mutual funds charge an annual fee called a load that may charge upfront, back end, or both. Loads vary depending on the type of mutual fund you buy. Some common loads include no-load, breakpoints (when you purchase between a specific dollar amount), and 12b-1 fees (also known as sales charges) to cover the distribution costs.
What is a Good Expense Ratio for ETF?
A good expense ratio should be between 0.2% to 0.75% for an actively managed portfolio.
Many financial advisors agree that anything greater than 1% is considered high. However, you still can consider the expense ratio up to 1.5% as a good bet if the fund’s historical returns and future prospects are promising. The decision entirely depends on your investment goals and objectives.
If two ETF options are almost identical in every other way, choose the fund with the lower expense ratio. Good expense ratios are usually due to a fund’s investment strategy. For example, an actively managed mutual fund will require more money to run than a passively managed fund like an ETF.
Good expense ratios are also linked to a fund’s asset size. A fund with many assets often has lower expenses than a smaller one.
The risk versus reward ratio is the most critical factor when evaluating any investment.
Given that you are investing your money, you must ensure that the potential rewards outweigh the risks.
A good rule of thumb is to look for an average expense ratio of 1% or below. It is important to understand that an expense ratio does not indicate how profitable a fund will be for you.
Consider the following example: Suppose you invested $1,000 each in two funds – Fund A charges 0.5% in annual fees, and Fund B charges 1%. At the end of the year, Fund A will have returned $1,050, while Fund B will have returned $1100. Fund A has a higher fee but has generated over twice as much income for you. Now calculate the expense ratio if that is too high to eat up a significant portion of your return. Discussing it with your financial advisor if you have any haziness is always better.
Why does the expense ratio matter?
Though the expense ratio has nothing to do with the fund’s performance, it matters.
A low-cost fund will typically fetch you a better return over time than one with a high expense ratio.
The cost of expense ratio is co-related to the amount of investment you make and the time horizon of your investment. The cost of investing compounds along with your investment returns.
Size of the fund matters. A smaller fund may have a low expense ratio. For example, if you invest $100,000, you will pay $500 in annual fees. If you invest $1,000, you will pay $5. Thus, the longer you hold security, the more you invest, and your fund expenses will be higher under the expense ratio framework. Since you are a long-term investor with a large amount of money, expenses will be a large part of your total costs.
Over time, an ETF’s performance may deteriorate if its expense ratio is excessively high and drags down the index’s performance or the underlying asset it tracks.
Let’s take a look at the below example of how the expense ratio makes a big difference:
Assume that with an initial investment of $10,000, you start investing in an ETF contributing $50,000 annually for 20 years at a 5% return. The expense ratio is only 1%.
At the end of your investment term, your investment will grow to approximately $2 million. You will pay $191,520 (using the expense ratio calculator) towards the cost of expense ratio. Now imagine if your expense ratio is more than 1%; how much will you lose out of your investment return over time?
The above calculation is simplified, overlooking taxes and other costs and expenses to hint at how the expense ratio works and why it matters.
How does the expense ratio affect my investment strategy?
The most common expenses are portfolio management, transaction, and marketing costs. While these fees can vary among funds, they can be considered excessive if the expense ratio of an index fund is higher than that of a mutual fund that offers similar services. This is simply because actively managed funds need much more skill and effort than passively managed funds such as Exchange-traded funds and Index funds.
Index funds generally have expense ratios ranging from 0.10% to 0.20%. Mutual funds are actively managed funds, and ETFs are passively managed. Therefore, there is a difference in expense between mutual funds and ETFs. Mutual funds have expense ratios between 1% – 2%, which may not seem like much but can add up over time.
The expense ratio measures how much an investment fund charges for every dollar invested. Expense ratios are a percentage, which is why they don’t directly tell you how much you’ll pay; however, they can give you a sense of relative value.
ETF’s expense ratio below 1% generally indicates a low-cost fund. If you’re investing in actively managed funds, an expense ratio below 1% may be preferable if you seek a higher investment return. However, if you are investing in index funds or ETFs, an expense ratio of 1% may not be ideal as it may not represent good value for your money.
How To Find The Fee Information You Need?
Most of the time, it is hard to find the exact information about the expense ratio. The expense ratios are less observable as these expenses associated with each fund are deducted from its total value on a regular basis and not itemized in the account statement.
The fee information can be found in the fund’s prospectus, a lengthy document that most of us avoid reading. Anyway, you can download the prospectus from the fund’s website.
You will find the Investment objective, Fund name, fund type, annual management fee (% of assets), Fees and Expenses, other expenses etc.
If you are interested in Exchange Traded Funds (ETFs), you must read the prospectus carefully. The most important section is usually the section regarding expenses. Search the ETF expense ratio on the internet with the fund’s name to find the same. Remember that the information found in a prospectus may be slightly different from information published on a fund’s website.
The other Investment Costs
Other charges are associated with investing in an ETF beyond the expense ratio, including interest and borrowing expenses, taxes, brokerage commissions, nonrecurring and extraordinary expenses, fund proxy expenses, and investment income tax, among others.
Fee-Only Fund and ETF
In the investment industry, the term “fee-only” refers to a securities broker-dealer firm that gets paid solely by its clients for its investment advisory and financial planning services.
A fee-only investment advisor does not receive any compensation from the investment companies whose products it sells. Instead, the firm’s revenue is derived from the fees that it charges its clients for providing financial advice and financial planning services. This contrasts with a commission-based investment advisor, whose revenue is derived from selling the investment company’s products.
In essence, the fee-only model is one where the client pays the advisor directly for the services provided, and the advisor is not paid by the investment companies whose products it recommends to the client.
Choosing a low-expense ratio fund will help you grow your money over time. The larger the fund’s expenses are, the less money is left over for investors.
When investing in a fund, it is essential to pay attention to its expense ratio. Given that almost all ETFs have an annual fee, finding one with a low expense ratio is important. Ideally, it would help if you look for an expense ratio below 0.5%.
Frequently Asked Questions (FAQs)
The asset-weighted average expense ratio measures the total expenses associated with owning and operating a mutual fund divided by the average value of the assets in the fund. The ratio is calculated by weighting the expense ratios of each individual fund in the portfolio by the percentage of assets it represents.
Active mutual funds tend to have an average expense ratio between 0.5% and 1.0%.
A fund with an annual expense ratio of 0.75% means you pay $7.50 yearly for every $1000 you invest.
The Expense Ratio is a sunk cost (a cost that cannot be recovered once paid) presented as a percentage of assets under management and measures all operating costs, including administrative, marketing and advisory expenses, along with other expenses such as transaction costs and marketing costs.
Vanguard’s average expense ratio is as low as 0.06%, probably one of the lowest offered expense ratios in the industry.