Investors looking for low-cost index funds typically believe that the internal expense is minimal. However, this may not actually be the case. Exchange-traded funds, also known as ETFs, typically follow a benchmark or index. Since this strategy is passive, ETFs tend to have a very low expense ratio. Most mutual funds, on the other hand, are actively managed investments that employ a team of portfolio managers and analysts. These analysts actively research and trade within a mutual fund, and thus cause a higher expense ratio that is passed on to the investor. However, some mutual funds are designed to follow an index and thus have a lower expense ratio, similar to an ETF.

How to Determine Fund Costs

The first step in determining a fund’s internal expense ratio, or cost, is to look at the fund company’s fact sheet or prospectus. This is expressed as both a gross and net expense ratio, which is computed as an annual basis percentage. Mutual funds can range from 0.5% to 4%, while ETFs range from 0.05% to 1.2%. For example, if an investor owns $10,000 in an ETF that has an expense ratio of 0.15%, the actual dollar fee would be $15. It is also important to understand that mutual funds and ETFs collect the expense ratio daily instead of quarterly or annually.

How Much Is Too Much?

When measuring fund costs, it is important to determine precisely what is most important to the investor. Mutual funds are more costly, on average, than ETFs. This is due to the portfolio manager’s ability to navigate the changing markets to achieve better risk-adjusted returns over a benchmark. For example, the T. Rowe Price Blue Chip Growth fund (TRBCX) has been run by the successful manager Larry Puglia since 1993. As of March 31, 2016, the fund has returned an annual 10-year average of 8.40%. This is net of the 0.72% expense ratio and surpasses the S&P 500 return of 7.01%. If an investor believes that a professional money manager can do better than a benchmark, he may consider the higher cost to be justified.

Index mutual funds and ETFs are passively managed and have little-to-no trading during the course of a year. This is precisely why these funds should have a low expense ratio compared to their actively managed counterparts. The SPDR S&P 500 (NYSEARCA: SPY) is designed to mirror the S&P 500 and therefore has a low net expense ratio of 0.09%.

Ways to Lower Costs

The easiest way to find a lower-cost fund is to find a suitable alternative that has a lower expense ratio. Vanguard ETFs are known as the lowest-cost funds in the industry, with an average expense ratio of 0.18 for its funds. Properly searching for funds that mirror the same index, and comparing expense ratios, can be accomplished using a variety of websites such as Morningstar or ETF Database.

One thing to note is that just because a fund is constructed to mirror an index does not necessarily mean it does it. The tracking error ratio is used to determine this exact measure. Funds with a high tracking error indicate that the fund does not exactly mirror the movements of the index.

Another way to lower expenses is to simply eliminate all expense ratios and directly purchase individual stocks. Robinhood Investments has a free brokerage account option with no commissions. Investors who are willing to do the work can purchase the basket of stocks that make up an index, exactly as an ETF would do. However, this requires more work and research. For example, the S&P 500 is made up of more than 500 individual stocks that are weighted by capitalization. Mirroring an index such as the S&P 500 is very complex and is an ill-advised move for a novice investor.

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