Investment management fees for exchange-traded funds (ETFs) and mutual funds are deducted by the ETF or fund company, and adjustments are made to the net asset value (NAV) of the fund on a daily basis. Investors don't see these fees on their statements because the fund company handles them in-house.
Management fees are just a component of the total management expense ratio (MER), which is what should concern investors.
- Management fees—which include expenses ranging from manager salaries to custodial services and marketing costs—reduce the value of an ETF investment.
- They are a subset of the total management expense ratio (MER).
- MERs are generally lower for passive funds than for active ones.
- Because fees compound over time, higher fees can have a large impact on overall investment returns.
As part of its normal operations, an ETF company incurs expenses ranging from manager salaries to custodial services and marketing costs, which are subtracted from the NAV.
Assume an ETF has a stated annual expense ratio of 0.75%. On an investment of $50,000, the expected expense to be paid over the course of the year is $375. If the ETF returned precisely 0% for the year, the investor would slowly see their $50,000 move to a value of $49,625 over the course of the year.
The net return the investor receives from the ETF is based on the total return the fund actually earned minus the stated expense ratio. If the ETF returns 15%, the NAV would increase by 14.25%. This is the total return minus the expense ratio.
The Impact of Fund Expenses
Fees are important because they can have a huge impact on your ultimate returns. A $100 investment that grows by 7% a year would be worth $197 in 10 years, without fees. Subtract a 1% annual fee, though, and the result is $179, meaning fund expenses have eaten up approximately 10% of your potential portfolio. Because fees compound over time, just like portfolio assets, the longer the investing period, the bigger the loss.
Ways to Minimize Expenses
Fees have generally come down in recent years, but some funds are nonetheless more expensive than others. A critical distinction here is passive versus active management.
Passive managers simply mimic the holdings of a stock index, often the S&P 500, sometimes with minor deviations. These "index fund" or "index ETF" managers periodically rebalance fund assets to match the benchmark index, and this, in turn, incurs trading costs, but they are usually minimal.
Active managers, as the name suggests, take a greater hand in choosing fund assets. This requires, among other things, expensive research departments that passive funds don't have, and usually a higher level of trading, which elevates transaction costs. All of this gets reflected in the MER.
Expense ratios for both active and passive funds are on the decline. For active funds, the asset-weighted average expense ratio dropped from 0.68% in 2018 to 0.66% in 2019, while expense ratios for passive funds declined from 0.14% in 2018 to 0.13% in 2019.
Annual Fund Fee Study
In its annual fund fee study published in 2020, Morningstar reported that for U.S. open-end mutual funds and ETFs the asset-weighted average expense ratio decreased from 0.48% in 2018 to 0.45% in 2019. Over the past two decades, the average expense ratio has been cut almost in half and Morningstar estimates investors saved $5.8 billion in fund expenses in 2019.
Investors are benefitting from less expensive fund options as competition between fund companies increases. According to Morningstar, companies are moving toward fee-based compensation models and away from traditional transaction-based models. Customer rejection of costly funds is evident in net inflows and outflows. In 2019 alone, the cheapest 10% of funds saw inflows of $526 billion.
The popularity of low-cost robo-advisors is another factor driving down the cost of wealth management services and putting pressure on fund companies to keep expense ratios low. Many investors are responding favorably to the rapid digitalization in investment services and the ability to build high-quality portfolios for a minimal cost using easily accessible online platforms. The worldwide robo-advisory market is expected to be valued at over $41 billion by 2027, growing at a compound annual growth rate (CAGR) of almost 32% between 2020 and 2027.