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Understanding Mutual Fund Expense Ratios

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mutual fund expense ratio
If you’re investing in mutual funds or exchange-traded funds (ETFs), the fund manager will charge fees to cover their various expenses. Those fees are collectively rolled into what’s known as an expense ratio, which is expressed as a percentage. This is the portion of your total account value that’s removed annually in fees. For more insight into mutual fund expense ratios and how to lower your costs, consider working with a vetted financial advisor.

Why Mutual Fund Expense Ratios Are Important

Understanding and comparing the expense ratios of different funds is an important task for any investor before you select any investment vehicle. Fees vary widely, and they can have a significant impact on your long-term savings, making it even more important to know what you’re getting into before investing.

While a mutual fund can have a good rate of return on the actual investments, you may be losing more money than is necessary for certain fees or expenses to run the fund. If the expense ratio is high for a mutual fund then you’ll likely want to consider other investments that have a better chance of maximizing your return.

Investors seek out low-expense ratios because fund expenses can have a direct impact on fund returns. Assuming all else is equal, the higher the expense ratio, the lower your return. And just as a small increase in your savings rate of annual returns can compound over the years, so too can a small increase in expense ratio take a big bite out of your nest egg over many years of investing.

Consider a fund that delivers a 5% annual return or profit. An expense ratio of 1% may sound minuscule, but it means that 20% of your fund’s earnings take a detour to the fund company’s coffers year in and year out. In contrast, a fund with a 0.25% ratio gives up just 5%.

You don’t want to get hampered by the large expense and fee costs when the market takes a turn as the return will decrease substantially. You could end up losing a significant amount of money over the years if you continue to invest in funds with such large expense costs.

How the Expense Ratio Is Calculated

The costs that go into an expense ratio vary greatly from fund to fund. But most expense ratios include outlays for fund management, marketing, recordkeeping, administration, compliance and shareholder services. With many mutual funds, a 12b-1 fee, which covers a fund’s marketing and distribution costs, makes up a large proportion of the expense ratio.

The fees are bundled into a ratio that is expressed as a percentage of your total assets with that fund, and deducted from the net assets on an annual basis. For example, a fund with $1,000 might have an annual expense ratio of 1%, meaning that $10 is deducted from your account to cover costs every year.

Some of the fund’s costs are not included in the expense ratio, such as sales commissions paid to a broker who sold you the fund (these are referred to as loads), or trading commissions and account services fees. These are classified as debits, and they are listed on account statements.

You can find the expense ratio for a fund when comparing funds on a brokerage site, as well as on the fund’s prospectus. They aren’t typically listed in your account statements, though.

Average Mutual Fund Expense Ratio

On average, an equity mutual fund had an expense ratio of 0.39% in 2021, according to the most recent survey by the Investment Company Institute. But this is just an average. Since the amount of effort that goes into managing funds depends greatly on its investment strategy, it stands to reason that expense ratios also demonstrate a considerable range. The ratio calculation depends on what type of fund you’ve invested in and who manages it.

Mutual funds that actively buy and sell securities will typically carry expense ratios between 0.50% and 1.50%. Some actively managed funds that employ options and other high-cost hedging strategies have higher fund expense ratios, though it’s rare to see a ratio north of 2.50%. Still, there are many mutual funds that employ more passive investing strategies and thus have lower expenses. That ICI report found, for instance, that target-date funds (which are commonly found in 401(k)s) have an average ratio of 0.40%. And index funds have much lower fees (more on them in a bit).

While exchange-traded funds have many similarities to mutual funds, they tend to have lower expense ratios, typically below 0.50%. That’s mainly because they’re more likely to use passive management strategies, including index investing. Such strategies don’t involve as much analysis as actively managed mutual funds.

Index funds are a group that includes both mutual funds and ETFs and are the quintessential passively managed funds, attempting to simply track the rise and fall of a market index. As you might expect given this passive approach, they generally have expense ratios at the low end of the scale: 0.25% or even below 0.10%. Vanguard, considered the pioneer of index investing, has stock index funds with expense ratios below 0.50%, which means that an investment of $10,000 would lose less than $5 a year to fees. Index funds are popular with many investors in part due to these low management costs.

Some investment companies, particularly online or robo-investors, have made low-cost investing a specialty. Generally, a passive investment vehicle will carry a lower expense ratio than an active vehicle. There are always exceptions, and rates can vary across types. This is one reason it can be wise for investors to explore multiple options and read the prospectuses that investment companies offer.

Is It a Good Ratio? Depends on Your Returns

mutual fund expense ratio

Generally, smaller funds can have higher expense ratios, since they have fewer assets to cover costs and thus need more from each investor. Funds that invest in international markets, which require more analysis and observation, can also require high expense ratios.

But the most significant factor determining what a “good” expense ratio is comes down to the investment strategy. Actively managed mutual funds command higher expense ratios, typically above 0.75% on average. Average expense ratios for passively managed equity index mutual funds and bond index funds are much smaller, typically under 0.10%.

At the end of the day, though, what really justifies an expense ratio is the fund’s returns, not its strategy. Paying more for an actively managed mutual fund is worth it if that fund outperforms the market significantly. It comes down to simple math: If a mutual fund charges 0.70%, but an S&P 500 index fund would have cost only 0.05%, then the mutual fund would have to beat the S&P 500 by more than 0.65% to justify the increased costs.

While some funds do indeed outperform in this way, active management hasn’t shown a consistent ability to beat the market over the long-term. That’s why many investors have come to prefer low-cost index funds and passive management strategies – which in turn has helped to bring down average expense ratios.

The Bottom Line

mutual fund expense ratio
While expense ratios are important, they are not the only factor that determines the quality of a fund. An investor seeking a high-yield investment may see a high expense ratio as an acceptable cost for a strategy that takes more risks but has the potential to deliver greater returns. Remember, though, that an expense ratio is charged on your total account value, not the gains you see in the market. That means that you’re paying the ratio even if the fund loses value. Ultimately, the best expense ratio may belong to the fund that reflects the goals of the investor and measures up to its closest competitors.

Tips for Understanding Expense Ratios

  • A financial advisor can help you find funds that balance fees, returns, and risk. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • Before you start sweating about fees, determine what kind of investment strategy you want to pursue. Depending on how active or passive that strategy is, you can then research what types of funds will best serve the strategy and comparison-shop the expense ratios.

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