The expense ratio of a mutual fund or ETF is a measurement of how much the investor pays to keep that fund going.
This expense isn’t paid out directly to the fund company, but instead is built into the price of the fund.
For example, let’s say a fund invested in the S&P 500 and had a 0% expense ratio. If the S&P 500 was exactly even for the year – returning 0% with no dividends – then your investment would be worth the exact same amount after one year.
If the fund had a 1% expense ratio, then your total investment would decline 1% for the year – even though the investments were even.
Most index funds have a very small expense ratio – ideally below 0.25%. Index funds are based on set asset allocation or benchmark (the index), and don’t require continuous decisions on what to invest in.
This differs from actively managed funds, where a person is the ultimate decision-maker. Actively managed funds tend to have a higher expense ratio to pay for the larger staff required to research and make decisions.
Expense ratios vary from 0% for a handful of funds all the way up to 9% (!). I personally wouldn’t invest in a fund above a 0.25% fee unless it was at a 401(k) where there were no better choices.
A fee of 1% may seem small, but it adds up! If your investments grow at a pace of 6% a year, then they would otherwise grow at 7% a year without this fee. That’s 14% of your gains every year going to pay for fees.
Here’s a look at just how much these add up over time.
My outlook on expense ratios goes like this:
- A difference between 0.05% isn’t worth changing brokerages for. There will always be other funds that charge less. Aim for a “good” fee, even if it’s not perfect.
- If there is a larger difference than that, then it may be time to change where you invest. Beware of any taxes if you move brokerages though.
- Compare the fee with others in the same category. Compare US bond funds with other US bond funds. Emerging Markets funds with other emerging markets funds.