The Expense Ratio
An expense ratio is the annual fee charged for holding a mutual fund or exchange-traded fund (ETF). For actively managed funds this fee compensates fund managers for overseeing the fund’s investments. For passively managed funds/etfs this covers stuff like licensing fees.
Expense ratios are expressed as a percentage of an investment into the fund. For example, a fund with an expense ratio of 0.5% would cost $5 for every $1000 you have invested for 1 year. The problem is that the fee is automatically deducted from your portfolio, so you never really “see” it.
I typically don’t buy mutual funds, but my previous employer’s 401K had us choose between 25 mutual funds. Initially I didn’t know the funds even had fees, then one day while exploring through Fidelity’s dashboard I noticed a Fees tab.
The expense ratios for the funds varied from 0.02% all the way to 0.47%. I was auto-selected into one of the more expensive funds, and unfortunately it didn’t perform justifiably better than the 0.02% fund. You might think that 0.45% isn’t that big, but the difference is massive over the course of the 401K.
Running through a 401K Example:
- $25,000 initial investment ($19,500 employee contribution + $5,500 employer match)
- Annual addition of $25,000 growing at 7% for 40 years
That’s right, there’s a $600K difference in the cost of the two funds over 40 years under our assumptions. The difference is potentially much more if the 0.02% fund performs better (which it has over the past 10+ years) and returns are more than 7%.
Closing Thoughts
There are a plethora of factors to consider when picking a mutual fund/etf to invest in and the expense ratio is only one of them. Overall the cheapest option doesn’t necessarily mean its the best option for your situation. Sure enough, the risks of the 0.02% fund might be higher than the 0.47% fund, but that’s an evaluation I’m responsible for.
P.S. This is not financial advice and I am not your financial advisor.
