Everything You Need to Know About Expense Ratios

on

If you want better investment returns, one of the smartest things you can do is find lower-cost investments.

Not only are smaller fees a good predictor of future returns (the smaller the better), but cost is one of the few investment variables that’s directly within your control. You can’t control the markets, but you can control how much you pay for the privilege of investing in them.

And while there are a number of potential fees to watch out for, the expense ratio of the funds you’re investing in is the most common and, in many cases, the most significant. Understanding it, and minimizing it, will go a long way towards making sure that you get the best investment returns possible.

So in this post I’ll explain what an expense ratio is, why it’s so critical to your investment success, and how you can minimize it.

What Is an Expense Ratio?

An expense ratio is simply the ongoing cost of investing in a mutual fund or exchange-traded fund (ETF), and it’s charged as a percentage of the money you have invested the fund.

For example, let’s say that a particular mutual fund has an expense ratio of 0.50%. That means that if you have $1,000 invested in that mutual fund, $5 will be taken out each year as a fee.

That fee is used to pay for the cost of operating the fund, which includes paying people to choose the fund’s investments, covering the administrative costs of running the fund, and in some cases covering the costs of marketing the fund.

Every single mutual fund and ETF has an expense ratio, so there’s no avoiding it. But it IS important to make sure that you’re not paying more than you need to.

Why the Expense Ratio Matters

Before getting into exactly how you can minimize your expense ratio, let’s step back and look at why it’s important.

It’s easy to look at a fee of 0.50% or 1% and assume that it’s too small to matter. I mean, how many of us would even notice a half a percent difference in the price of the groceries we buy — if a carton of milk cost $1.99 instead of $1.98? Anyone?

But the truth is that a 1% fee really adds up when you’re contributing a significant amount of money over a long period of time.

For example, let’s assume that you and your spouse are both maxing out your IRAs, meaning you’re contributing a combined $11,000 per year. And let’s also assume that you get an 8% annual return over a 30-year period until you reach retirement age.

In that situation, a 1% fee would end up costing you a total of $234,001.

Or, to put it another way, simply finding a similar investment that only costs 0.20% per year would give you an extra $183,208 in retirement.

I don’t know about you, but that extra money would make a difference for me and my family.

What Is a Reasonable Expense Ratio?

Of course, you have to pay something. All mutual funds and ETFs have an expense ratio, so the real question is: What’s a reasonable price? When evaluating your investment options, what kind of expense ratio should you be looking for?

The good news is that expense ratios are generally on the decline. With the rise of index funds, there’s been a lot of pressure on investment companies to decrease the cost of their funds, and that’s meant good things for investors.

For example, you can easily find multiple S&P 500 funds that cost less than 0.10% per year. Even many bond funds and international stock market funds cost less than 0.20% per year.

And Vanguard also offers a suite of target-date retirement funds and other all-in-one funds that give you access to a wide range of investments and have expense ratios ranging from 0.12% to 0.16%.

In other words, there are a number of ways to access high quality investments at a low cost and I would generally view any expense ratio that’s 0.20% or lower as very reasonable.

With that said, a Morningstar study from 2015 found that the average expense ratio across all mutual funds and ETFs was 0.64%. And especially within 401(k)s, where you have a limited investment selection, it’s still common to see expense ratios above 1%, which is quite frankly ridiculous in this day and age.

So in some cases you may have to make the best of a bad situation. But when you have control over your investments, like within an IRA, you should be able to find good funds with an annual cost of 0.20% or less.

How to Find a Mutual Fund’s Expense Ratio

Unfortunately, figuring out what a mutual fund’s expense ratio is can be tricky. Especially with a 401(k), the costs are often not presented right up front and you’ll have to do a little digging.

When dealing with your 401(k), ask your HR department for a complete list of the investment options within your 401(k) and the fees associated with each. Hopefully this results in a simple document that clearly shows the expense ratio of each fund within your 401(k).

But in my experience that’s not always what you get. Sometimes you just get a list of funds, and you have to either ask again or do some research yourself.

At that point what you’ll need is the ticker symbol for each fund. The ticker symbol is a short string of letters in all caps, looking like this: VFINX (the ticker symbol for Vanguard’s S&P 500 mutual fund).

With that in hand, you can use a site like Morningstar to look up the fund and quickly find the expense ratio. There are plenty of other sources you can use as well, like going directly to the website of the company that owns the fund. But no matter what site you use, having the ticker symbol will make it pretty simple.

You can use that same process for looking up the expense ratio of funds you’re considering for an IRA, health savings account, brokerage account, or anything else.

Cost Matters

The bottom line is this: Minimizing your cost is one of the best ways to increase your investment returns, and minimizing your expense ratio is one of the best ways to minimize your cost.

So if you want to be a good investor, paying close attention to the expense ratio of the funds you’re investing in is a good start.

Related Articles:

Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.

The post Everything You Need to Know About Expense Ratios appeared first on The Simple Dollar.

Comments

Post a Comment