A mutual fund's expense ratio is very important to investors because fund operating and management fees can have a large impact on net profitability. The expense ratio for a fund is calculated by dividing the total amount of fund fees—both management fees and operating expenses—by the total value of the fund's assets.
Expense ratios for mutual funds vary widely. Expense ratios for index funds are significantly lower than for actively managed portfolio funds, averaging 0.06% in 2020. Expense ratios for actively managed funds averaged 0.71% in 2020, but some funds have much higher expense ratios.
Most investors do not realize the significant impact of a seemingly small percentage difference in mutual fund expense ratios, but an example easily demonstrates that even a relatively small difference has a significant effect on net investment profits.
Consider two mutual funds, both generating an average annual investment return of 5%, with one fund charging fees of 1% and the other charging 2%. The single percentage point difference may not seem significant to most investors, but it is because the fee amount is based on assets under management, not the profit earned.
Assume two investors begin the year with respective $100,000 investments in the 1% and 2% expense ratio funds, and each fund generates a 5% return on investment before fees are deducted. The investor being charged 1% in fees loses $1,000 (1% of $100,000) of his $5,000 profit to fees. The investor paying 2% in fees pays $2,000 of their $5,000 profit. Thus, the small 1% difference in expense ratios translates to a whopping 10% difference in net profits.
Correction–Dec. 31, 2021. This article was corrected to accurately reflect the formula for a mutual fund's expense ratio.