Expense Ratio Explained in Plain English

Let’s talk Expense Ratios. Sounds super boring I know. Here’s the thing though…

… if you wanna build your own nest egg instead of pad the pockets of Wall Street fat cats, it pays to know what expense ratios are.

So below we’ll look at what expense ratios are, why you should care, and some other helpful odds and ends about this hidden profit killing expense.

What Is An Expense Ratio?

When you buy a mutual fund or ETF, there are people who manage that investment. And those people have costs associated with managing that fund or ETF. Accounting fees. Legal fees. Reporting fees. Armani suit fees.

Okay, made the last one up. But you get the picture. These are just the costs of doing business for a fund’s management team.

To cover the cost of these admin fees, funds and ETFs charge you what’s called an expense ratio. It’s an annual fee that gets invisibly deducted from your returns. You won’t get a bill for this fee.

An expense ratio is calculated by dividing all these costs by the funds/ETF’s average net assets.

At the end of the day, this is what it means to you…

… if you invest $10,000 in a fund/ETF with a 1% expense ratio, then $100 will automatically get swept outta your investment each year, never to be seen again.

Fees Not Included in the Expense Ratio

Keep in mind, the expense ratio doesn’t include all the fees you could be charged when investing in a mutual fund/ETF.

Any trading fees or brokerage cost the fund has for buying/selling stocks are not included. Also, if the fund charges a sales load when you buy/sell your shares, that ain’t included either.

(Quick note: This is a topic to dig deeper into another day, but NEVER buy a mutual fund that charges a sales load. Got it? Good! Okay, now back to your regularly scheduled program…)

Why Expense Ratios Matter

It’s a cost. And any cost you pay for investing reduces your returns.

Even a small difference in fees can add up to big bucks over time. Here’s an example…

Let’s say you invest $10,000 in an index fund that has low expense ratio of 0.1% (which is actually above average for an index fund). You add nothing else to those 10Gs. You just let them sit for 20 years and you average a 10% return. Over that time, the expense ratio will cost you $1212.68.

Now let’s say you invested that $10,000 in a actively managed mutual fund with an expense ratio of 2.5%. Again, you add nothing else and just let that sit there for 20 years and you average a 10% return. That will cost you a whopping $24,796.49 in fees over that time!!!

That’s a difference of $23,583.81!

That’s money that could have gone toward your dream home, an around the world vacation or some of that Weird Al Yankovic autographed memorabilia you’ve had your eyes on for years (hey, we’re not judging here!).

Instead, that money funded the steering wheel on some fund manager’s 5th Ferrari.

Now if actively managed funds had returns that trounced those of index funds, then the added expense ratio would be totally worth it. But the truth is, over the long haul, there are precious few that do.

Where to Find Expense Ratios

Expense ratios are super easy to find. All you need to do is look up whatever fund or ETF you’re considering investing in on a site like Yahoo! Finance.

A Few More Odds and Ends About Expense Ratios

When comparing the expense ratios of funds/ETFs, you’ll want to compare funds/ETFs that target similar investment types.

Because the expense ratios charged by a gold ETF vs one charged by an international fund vs one charged by a large-cap fund will be different. (Large-cap funds will tend to have the lowest expense ratios and international funds the highest.)

Index funds that invest in stocks have an average expense ratio of 0.09% according to a 2016 report from the Investment Company Institute. Actively managed funds have an average expense ratio of 0.63%.

The Bottom Line on Expense Ratios

Expense ratios aren’t the end all be all. There are plenty of other considerations to think about before investing in a mutual fund or ETF. But expense ratios shouldn’t be ignored.

The good news is that they have been falling over the past few decades and are much lower these days. But, if you ignore them (especially for funds you have to pick in a 401K plan), you could be in for a nasty surprise when you see how much of your money you’ve been shoveling over to fund managers.