Investing in stocks can get you closer to your long-term financial goals. These assets gain value as the corporations issuing shares report revenue and earnings growth. While some investors look for individual stocks that can outperform the market, others stick with funds.
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Mutual funds and exchange-traded funds, or ETFs, each offer investors exposure to many stocks. These funds offer a simpler path to investing in the stock market and do not require as much involvement from investors. Some funds track popular indexes and help investors match market returns instead of striving to outperform the market. Other funds are actively managed and aim to exceed market returns.
While many brokerage firms have removed trading fees for stocks and funds, there is still a “silent cost” associated with each of these funds. Investors can determine this silent cost by looking at a fund’s expense ratio. Here’s what you need to know about these fees:
— Introduction to expense ratios.
— Calculation of an expense ratio.
— Factors affecting expense ratios and total costs.
— Importance of expense ratios in investment decisions.
— Ways to minimize expense ratios.
[READ: 8 Best Income ETFs for 2024]
Introduction to Expense Ratios
Mutual funds and ETFs offer diversified portfolios and allow you to save time on research and portfolio management. However, if no one monitored these funds, they could fall behind a benchmark or hold onto unprofitable investments for too long.
So a portfolio manager oversees each fund, and the associated costs are part of the funds’ total expenses. One investor doesn’t bear all of the expenses; instead, the expenses get distributed to each investor based on how much money they put into the fund.
Definition and Basics of Expense Ratios
“An expense ratio is the percentage an investor will pay annually for management, administrative and other operating expenses of the fund,” states Emily Cozad, portfolio manager and investment specialist at Buckingham Advisors.
Any necessary expenses to maintain the fund are included in the expense ratio. Portfolio managers overseeing actively managed funds may also have more trading fees if they buy and sell derivatives like options. Those extra fees will result in higher expense ratios for investors.
Calculation of an Expense Ratio
Most fund managers quickly point out the expense ratio so you don’t have to calculate it. However, understanding how the calculation works can help you determine which types of funds tend to have low expense ratios.
Robert Johnson, professor of finance at Creighton University’s Heider College of Business, offers a concise example of how to calculate this ratio: “If a fund has average assets under management of $100 million and $500,000 in operating expenses, the fund has an expense ratio of 0.5%, or 50 basis points.”
Funds with higher total assets tend to have lower expense ratios because the same costs get distributed among more investors. For instance, the SPDR S&P 500 ETF Trust (ticker: SPY) is the largest ETF in the world. The vast amount of assets in the fund exceeds expenses by a wide margin, resulting in a low 0.09% expense ratio.
Actively managed funds tend to have higher expense ratios than passively managed funds like SPY.
Factors Affecting the Expense Ratio and Total Costs
The expense ratio isn’t the only number that indicates your total costs of having a fund instead of individual stocks. Investors must also consider how much money they put into the fund. The more capital you invest in an ETF or mutual fund, the more you’ll pay.
Impact of a High Expense Ratio on Returns
If you invest $100,000 into a fund with a 1% expense ratio, your cost for the year comes in at $1,000. If the position in your fund grows to $200,000, you will pay $2,000 in expenses for storing your money in the fund. If the fund loses value, the amount you pay in administrative fees also goes down.
You won’t pay this money upfront. Instead, it will get deducted quietly from your fund’s position.
Impact of a Low Expense Ratio on Investments
However, investors hope that they can generate a higher return than the posted expense ratio to profit from their investments. Opting for a lower expense ratio can help you save considerable money. Putting the same $100,000 into an ETF with a 0.1% expense ratio only results in a $100 annual charge. So, in this example, the difference between a 1% expense ratio and a 0.1% expense ratio is saving $900 annually.
Importance of Expense Ratios in Investment Decisions
A lower expense ratio allows you to keep more of your money. Paying lower fund fees also leaves more money invested that can compound each year. You can find many funds with expense ratios under 1%, but you may have different expectations based on the type of fund you want to invest in.
Fund Type and Expense Ratio
“That depends upon the type of fund, specifically whether it is passively managed or actively managed,” says Johnson.
Actively managed funds have higher expense ratios because fund managers have to stay on top of them more often. These funds may have more frequent trades or employ more complex strategies.
While the passively managed SPY ETF has a 0.09% expense ratio, or $9 annually for every $10,000 invested, the actively managed Global X Nasdaq 100 Covered Call ETF (QYLD) has an 0.6% expense ratio, or $60 annually for every $10,000 invested. QYLD portfolio managers sell covered calls, which involves more management effort and higher trading fees.
Investment Strategy and Expense Ratio
Comparing actively and passively managed funds in a similar sector can help you determine a reasonable expense ratio.
“A favorable expense ratio for an actively managed fund might be 0.5% or less. Actively managed funds are attempting to outperform a benchmark or meet a specific goal,” Cozad says. “A good expense ratio for passively managed funds may be 0.1% or less. Passively managed funds are those that aim to replicate an index and attempt to match the benchmark’s performance as closely as possible.”
Ways to Minimize Expense Ratios
Investors looking for lower expense ratios should start their search with passively managed funds with a high amount of total assets.
Fund Size and Expense Ratio
Funds with billions of dollars in assets under management can spread their costs more efficiently. Big-name brokerage firms like Vanguard and Fidelity have a wide selection of passively managed funds with low expense ratios. It’s very possible to find many ETFs and mutual funds with expense ratios below 0.1%, especially if you look for index funds.
Opting for Passive Funds
“Index funds can afford to have lower expense ratios because they are passive investment vehicles. That is, one isn’t paying financial professionals to select investments,” Johnson explains.
It’s essentially a popularity contest. Funds that are more popular and well known usually have more capital because more investors pour money into them. The extra capital translates into lower expense ratios compared to smaller funds that are trying to get established.
Comparing Fund Options and Expense Ratios
Seeing what large brokerage firms offer is a great starting point. However, investors can also use screeners to discover funds with expense ratios below 0.1%. These screeners have additional parameters, such as a minimum return over the past five years. Using a screener can reveal funds with low expense ratios that have been top performers.
Investors should look at a fund’s historical performance, holdings and other components instead of only looking at expense ratios. The VanEck Semiconductor ETF (SMH) has been a good example of what can happen if investors look beyond the expense ratio. The ETF has a 0.35% expense ratio, which is reasonable but higher than that of many other passively managed funds. However, the fund has delivered a 71.9% year-to-date return for investors as of Dec. 18, which far exceeds more popular choices like SPY.
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What Is an Expense Ratio? originally appeared on usnews.com
