All mutual funds and exchange-traded funds (ETFs) charge their shareholders an expense ratio to cover the fund’s total annual operating expenses. Expressed as a percentage of a fund’s average net assets, the expense ratio can include various operational costs such as administrative, compliance, distribution, management, marketing, shareholder services, record-keeping fees and other costs. The expense ratio, which is calculated annually and disclosed in the fund’s prospectus and shareholder reports, directly reduces the fund’s returns to its shareholders, and, therefore, the value of your investment.
According to a report published by the Investment Company Institute (ICI) entitled Trends in the Expenses and Fees of Mutual Funds, 2012, expense ratios incurred by investors in long-term mutual funds have, on average, declined over the past 20 years. Equity fund expense ratios, for example, fell from an average of 1.07% in 1993 to 0.77% in 2012. Hybrid funds went from 0.96% to 0.79%, bond funds dropped from 0.83% to 0.61%, and money market funds fell from 52% to 17% over the same 20-year period.
The trend in lower expense ratios can be attributed to a variety of factors, such as money market funds waiving expenses to ensure that net returns remain positive during periods of low interest rates, and target date mutual funds being able to lower expenses due to economies of scale (target date mutual fund assets have tripled since 2008). In addition, expense ratios often vary inversely with fund assets, meaning that as a fund’s assets increase, its fixed costs likely represent a smaller percentage of its net assets; therefore, its expense ratio can correspondingly decrease. Despite trends indicating an overall decrease in fees across many fund categories, investors should still pay attention to expense ratios: even small differences in fees can have a significant impact on your investment over time.
Expense Ratios Differ
In general, the expense ratios for mutual funds tend to be higher than for ETFs. While ETF expense ratios top out around 2.5%, mutual fund costs can be as high as 20% (most, however, are much lower). The costs of operating funds vary greatly depending on the investment category, investment strategy and the size of the fund, and those with higher internal costs generally pass on these costs to shareholders through the expense ratio. If a fund’s assets are small, for example, its expense ratio might be relatively high, because the fund has a restricted asset base from which to meet its expenses.
When looking at funds and costs, it is important to compare funds that own similar types of investments. For example, international funds are typically very expensive to operate because they invest in many countries and may have staff all over the world (which equates to higher research expenses and payroll). Large cap funds, on the other hand, tend to be less expensive to operate. While it is reasonable to compare expense ratios across multiple international funds, it would not make sense to compare the costs of an international fund against a large cap fund.
When researching investments, there are several ways you can determine the expense ratio of a fund:
- The fund’s prospectus - If you are already a shareholder, the prospectus will be mailed or sent electronically to you each year. The expense ratio is typically found under the “Shareholder Fees” heading. You can also view the prospectus on the fund company’s website.
- Financial news websites - Websites such as Google Finance and Yahoo! Finance have expense ratio information for mutual funds and ETFs. Type in a fund’s ticker symbol to view this information.
- Fund screeners - A number of ETF and mutual fund screeners are available online. You can search by category or group (i.e., equity, bond, money market, international) and compare expense ratios across similar investments. FINRA’s Mutual Fund Expense Analyzer, for example allows you to compare up to three mutual funds (or ETFs) or the share classes of the same mutual fund. The tool estimates the value of the funds and impact of fees and expenses on your investment.
- News journals - Print newspapers, such as Investor’s Business Daily (IBD) and the Wall Street Journal print information regarding funds, including expense ratios.
Rates Affect investments
To see how expense ratios can affect your investments over time, let’s compare the returns of several hypothetical investments that differ only in expense ratio. The following table depicts the returns on a $10,000 initial investment, assuming an average annualized gain of 10%, with different expense ratios (0.5%, 1%, 1.5%, 2% and 2.5%):
As the table illustrates, even a small difference in expense ratio can cost you a lot of money in the long run. If you had invested $10,000 in the fund with a 2.5% expense ratio, the value of your fund would be $46,022 after 20 years. Had you instead invested your $10,000 in the fund with a lower, 0.5% expense ratio, your investment would be worth $61,159 after two decades, a 0.33% improvement over the more expensive fund. Keep in mind, this hypothetical example examines funds whose only differences are the expense ratios: all other variables, including initial investment and annualized gains, remain constant (for the example, we must assume identical taxation as well). While two funds are not likely to have the exact same performance over a 20-year period, the table illustrates the effects that small changes in expense ratio can have on your long-term returns.
The Bottom Line
While important, a fund’s expense ratio is not the only important consideration when analyzing and comparing fund investments. Investors must consider a variety of factors, including each fund’s:
- Sales charges
- Age and size
- Risks and volatility
- Recent changes in operations (for example, has the fund’s investment adviser changed?)
- Impact on your portfolio diversification
It should be noted that a fund’s expense ratio represents your cost of owning the fund – not purchasing or redeeming the fund (sales loads). Any initial or deferred sales charges, transaction fees or brokerage charges are not included in the expense ratio. All of these factors should be taken into consideration prior to making any investment decisions. With research, you can find funds that meet your goals and objectives while leaving more money in your portfolio.
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