Investing

What an expense ratio is and why it's important

Twenty/20

In recent weeks, brokerages including Charles Schwab, E-Trade, and TD Ameritrade have cut trading fees, or the expense charged just to buy into a fund. But even without that upfront expense, investing typically still isn't a totally fee-free endeavor.

A key fee to be aware of: expense ratios. You'll see this figure on an ETF or mutual fund's fact sheet or prospectus, often without any kind of further explanation.

Here's what you need to know about expense ratios, and how they apply to your money.

Expense ratios cover a fund's expenses

An expense ratio relates to the costs associated with running a mutual fund or ETF. To cover those costs, funds tend to charge a percentage of any money you invest, kind of like how you tip on the total amount of money you spend at a restaurant.

This ratio or percentage can seem pretty abstract on its own, so it may be helpful to think of it in terms of cost per $1,000 invested. An expense ratio of 1% means $10 of every $1,000 you invest goes to fund costs each year.

Overall, the average expense ratio is 0.48%, according to Morningstar's 2018 fee study. That's equivalent to $4.80 per every $1,000 invested. But expense ratios can vary widely depending on what kind of investments you have.

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Active funds, which are those that are continuously managed and curated by investment professionals, have average expense ratios of 0.67%, or $6.70 per $1,000. These funds tend to be pricier because there are simply more costs associated with running them. They require larger staffs to research investments aimed at beating average market performance and must cover taxes and fees associated with regularly buying and selling component investments.

Even passive index funds have some overhead: They still require someone to perform periodic maintenance when shareholders add or withdraw money, or the index the fund tracks reevaluates its holdings. But their costs tend to be very low, with average expense ratios of 0.15%, or $1.50 per $1,000.

That means those investing in active funds pay over four times more in fees than those who invest in passive funds.

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And that higher expense doesn't necessarily translate to bigger returns. It's very hard even for experts to consistently beat the market — and, by extension, for active funds to outperform passive funds.

While select actively managed funds may outperform their benchmarks, and their related index funds, over the short term, less than 10% manage to do so successfully after more than 15 years, according to data from S&P Dow Jones Indices.

Where to find a fund's expense ratio

To find your fund's expense ratio, check its prospectus or fact sheet. You can also quickly find your funds' expense ratio on investment resources like Morningstar, Kiplinger or the Securities and Exchange Commission websites.

How an expense ratio affects your bottom line

Expense ratios accrue as a percentage of the average daily returns and are baked into a fund's performance information. That means if your fund is up 10% and has a 1% expense ratio, you'll actually see returns of 9%.

While it seems like a small difference in fees from one fund to another can really add up over time. The Center for American Progress calculated that, over the course of a 42-year career, someone who invests in low-cost index funds with expense ratios of 0.25% could have nearly $100,000 more at retirement than someone who invests in funds costing 1.3%.

An awareness of expense ratios helps you keep more of your money working for you instead of going toward a fund's operating costs. That's why most experts recommend a diversified portfolio of low-fee, passive ETFs.

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