Investing in mutual funds and exchange-traded funds are great ways for smaller investors to begin investing in the stock market. They are also a great way for people without a lot of money to invest in the stock market. But they have an ugly secret, an expense ratio.
While on the surface you might overlook the dark side of an expense ratio, after all, mutual funds and ETFs are helping you to grow your wealth, if you completely ignore them, they can easily cost you thousands of dollars. And in some cases, much much more.
In this post, I am going to walk you through what an expense ratio is and how it is robbing you of your money. By the end, you will see that you need to pay more attention to this fee your favorite investment is charging you.
What Is An Expense Ratio
An expense ratio is a fee a mutual fund or exchange-traded fund charges investors. The fee is also known as a management fee. Since these types of investments have a management team picking the investments and managing the daily operations of the funds, they charge this fee as their payment.
As a result, all mutual funds and exchange-traded funds charge this fee. Don’t think you can find an investment that doesn’t. But what you will find is they all charge a different amount.
Typically you will see that mutual funds and ETFs that are index funds charge a much lower management fee. This is due to the lack of turnover in the fund. Since the investment is tracking an index, there is not much work for the management team to do.
As a result, they charge a lower fee. But if you have a mutual fund that has a very high turnover rate, then you can expect a high management fee.
What is considered high? Anything over 1% is high. In fact, I would argue for mutual funds that own US stocks you should not be paying anything over 0.30%. For bonds, nothing over 0.50%, and for international stocks, nothing over 0.70%.
In fact, some readers of this might even think these numbers are high. The bottom line is you want the expense ratio to be as close to zero as possible.
One way to avoid expense ratios is by investing in Motley Fool stock picks.
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How An Expense Ratio Is Robbing You
OK, so you now know that mutual funds and ETFs charge a fee, but in almost all cases it is less than 1%. What is the big deal then? Why are we so worried over such a minuscule fee?
The reason is that this minuscule fee is really a large fee when you look at it long-term.
Let’s say you have $5,000 invested in a mutual fund that is charging you a 1% management fee and your investment grows at 8% annually.
After 1 year, your money grew to $5,346 and you paid a $54 management fee. Not too bad.
But let’s look at the same example over the course of 20 years. After 20 years your $5,000 grew to become just over $19,000 and you paid a $2,195 management fee.
You might be thinking again this isn’t too bad. But what you aren’t seeing is the opportunity cost. Since the expense ratio is taken from the mutual funds gains, you lose the chance to have your money compound into greater sums of money.
The opportunity cost in this example is $2,049.
Here is how this looks in real life. We will take your $5,000 and invest it at 8% annually for 20 years and in a mutual fund that charges a 0.10% expense ratio.
At the end of the 20 years, you have close to $23,000 and you paid roughly $250 in management fees.
Because you invested in a fund with a lower expense ratio, more of your money was able to compound on itself and grow more.
The result is you end up with close to $4,000 more!
And this is just looking at a one-time $5,000 investment. Imagine your 401k plan or other investment accounts that you are adding money to consistently and is worth tens of thousands of dollars.
The point is, you need to pay attention to expense ratios because they are robbing you of your money.
So there you have the truth behind the expense ratio you are paying. Understand that I am not suggesting you completely avoid all mutual funds or exchange-traded funds. I see many great benefits of these types of investments and they are where I invest the majority of my money.
But you cannot just blindly pick a mutual fund or ETF. You have to understand the underlying fees they are charging and how that fee is going to impact you long term.
When you do this, you become a better investor and one who ends up keeping more of your money over the long term.