These days, there is no shortage of low-cost investing tools and platforms. That’s great news for investors, but it doesn’t mean there aren’t still costs.
In addition to mutual funds, many investors are turning to exchange-traded funds (ETFs). Both of the investments have associated expense ratios.
These expense ratios are calculated by taking a small percentage of your total portfolio value. While these fees are relatively small for robo-advisors, they can be high for human financial advisors.
Thus, you should be aware of expense ratios and when to consider moving investments if fees are too high.
Expense Ratios Explained
Expense ratios cover all of the fees associated with an ETF or mutual fund. This may include administrative costs, marketing, and paying fund managers.
Whether you are investing in a mutual fund through your employer-sponsored retirement plan or a Betterment portfolio, you will incur expense ratios.
However, these expenses are usually higher for mutual funds than for index funds. That is because mutual funds are actively managed.
In other words, mutual funds have real humans who manage the funds. They handle everything from selecting investments to rebalancing to carrying out trades.
If there are humans actively managing the fund, they will usually try to beat market benchmarks. This may further inflate fees.
On the other hand, index funds use algorithms to carry out most or all of these duties. That allows them to have significantly lower fees.
Unlikely actively-managed mutual funds, index funds try to match the performance of an index such as the S&P 500. There are licensing costs associated with this tracking which the expense ratios cover.
Expense Ratio Calculation
The expense ratio is calculated as:
Total fund expenses / total assets under management
Hence the term ratio - it is the ratio of expenses to the total assets under management.
However, for many funds and robo-advisors, the expense ratio is pre-determined. For example, VTSAX has a 0.04% expense ratio.
In this case, the fees you pay are your portfolio balance * 0.04%.
So, if you have $50,000 invested in VTSAX, your fees for the year are $50,000 * 0.004 = $200.
How These Fees Are Charged
Expense ratios are charged as a percentage of your portfolio. You won’t receive a bill that says how much you owe, however.
Instead, your expense ratios will simply be subtracted from your overall return. The fees are usually negligible, especially if the expense ratio is low.
For example, Vanguard’s new Digital Advisor has just a 0.15% expense ratio. That works out to a fee of $4.50 per year on $3,000 invested.
Typical Expense Ratios
Expense ratios can vary quite a lot depending on a number of factors. However, the biggest determining factor is whether the fund is actively managed or passively managed.
A reasonable expense ratio for actively-managed funds is in the 0.50% to 0.75% range.
Once you get over 1%, and especially 1.5% - it’s time to start weighing your options.
Index funds, or passively-managed funds, have much lower expense ratios. About 0.20% is typical these days, but they can be as low as 0.02%.
And, these days, it gets even better than that. Companies such as Fidelity have added funds with no expense ratios at all.
This is what’s considered a “loss leader” - a product the company uses to attract customers.
Thus, while it doesn’t make money from the fund itself, it believes it can more than make up that loss by selling other products to new customers.
These are just some general numbers, but, of course, the lower the ER, the better.
What Does it Mean for Your Portfolio?
Expense ratios will always lower your overall return. Therefore, it’s important to know your fees.
Newer investors may hear they are paying a 1% fee and think that’s a small number. If it’s only 1%, it must not have much of an impact, right?
In reality, that couldn’t be farther from the truth.
Let’s say you start with a $5,000 investment and add $10,000 to it every year for 30 years. Now, let’s look at how the fees on this investment play out with two different fees:
- Fees over 30 years, 0.04% ER: $6,255.44
- Fees over 30 years, 1.5% ER: $202,491.07
That’s right: a 1.5% fee would cost you over $200,000 over the course of 30 years.
While 1.5% is a high fee these days, this illustrates how much of a difference this seemingly small fee can make.
One thing to keep in mind is that, due to compounding, increasing the fees has an exponential effect on how much you actually pay. It’s not a linear increase.
That’s because you pay fees every year. And as your portfolio grows, that higher fee is being charged against higher and higher balances.
As your portfolio grows more rapidly, so will the total fees you pay.
This is why it’s so important to pay attention to fees and understand how much they can actually impact your portfolio.
However, you shouldn’t fuss too much about saving 0.05%, for example. While this could make a slight difference over several decades, you also have to account for capital gains taxes when selling investments.
Thus, it’s important to consider the whole picture.
Fees are certainly important, but they aren’t the only thing that matters. There are several other factors, such as tax efficiency, risk tolerance, and even your values.
Some ETFs are inherently more diverse than others, which you may prefer if you have low risk tolerance. On the other hand, if you prefer investing responsibly, you might be willing to tolerate higher fees to meet that goal.
In addition, you may have relatively high expense ratios on mutual funds in your employer-sponsored retirement plan. However, your employer may offer matching contributions that outweigh the higher fees.
As you can see, it’s important to think about the whole picture.
Expense ratios are fees that may be charged to pay fund managers, for marketing and licensing, and to cover administrative costs.
You can expect expense ratios to be higher for actively-managed funds than for passively-managed ones. High fees can be tolerable in some cases, such as with employer-sponsored retirement plans and socially-responsible investments.
Nevertheless, it’s important to know your fees and understand the full impact they have on your portfolio.
Otherwise, you could end up spending tens of thousands or even hundreds of thousands of dollars on fees without even being aware of it.