Each year, a fund will take a cut, expressed as a percentage of your initial investment, to cover the costs associated with overseeing your money. The expense ratio of a mutual fund is calculated by dividing the annual operating costs by the average net asset value of the fund during the year.
Mutual funds and exchange–traded funds (ETFs), a type of index fund, both have expense ratios. Because they are passively managed by quantitative strategies rather than actively managed by subjective humans, many index funds have low expense ratios.
Methods for Figuring Out an Expense Ratio
Expense ratios are disclosed by funds even though they are calculable. One can easily find the expense ratio of a fund by reading the “general information” section of the fund’s fact sheet.
The expense ratio of a fund can be used to estimate the yearly cost of investing in that fund. To calculate your total annual fee, multiply the expense ratio of the fund by the amount you have invested. To put it another way, if the expense ratio of a fund is 1.5% and the value of your investment is $1,000, you will pay $1.50 per year to the manager of the fund.
Expense Ratio: What You Need to Know
For investors who plan to hold onto their stocks for the long haul, the expense ratio is crucial because even a seemingly insignificant shift in the expense ratio can have a major impact on long-term returns.
Compare a mutual fund promising 8% annual returns for the next 20 years to an index fund that passively tracks a major stock market index and promises 7% annual returns. The index fund has a lower expense ratio of 0.40% compared to the actively managed mutual fund’s 2%. Investing the same amount of money in both the mutual fund and the index fund would yield a return of $320,000 and $360,000, respectively.
There is a common misconception that active fund management results in higher investment returns. However, a study by fund manager Meb Faber found that the most common asset allocation strategies employed by active managers result in roughly the same returns. There was only about a one percent performance gap between the best and worst active strategies.
In the previous illustration, the expensive mutual fund produced better long-term results than the low-cost index fund. Large mutual funds, on the other hand, often mirror the performance of the market indexes they aim to outperform, and large mutual funds, in general, have a poor track record of outperforming the indexes they track.
Understanding the expense ratio of a mutual fund is the first step in making an investment decision. If it’s greater than 1%, continue.
How Expense Ratios Are Composed
Fund expense ratios tend to be fairly consistent, but they are subject to change because some expenses are more fluid than others. The management fee is the largest expense of any fund, whether actively or passively managed, and is always expressed as a percentage of assets. This is the compensation received by the fund managers; it is greater for active managers.
Accounting fees, registration fees, reporting fees, and other miscellaneous costs are all examples of the variable expenses funds incur. It is required by the U.S. Securities and Exchange Commission that a fund’s marketing costs do not exceed 1% of the fund’s average assets and that these costs be reported separately (SEC).
Expense ratios can be kept low by charging only a nominal fee for management by some funds, most commonly index, and passively managed funds. An investment company can cover its operating costs with the interest it earns from lending its shares to short sellers.
For what doesn’t the ratio account, exactly?
Actively managed mutual funds may pay substantial trading commissions to brokerages, which are not covered by the expense ratio paid by investors since passively managed index funds make few if any, changes to their holdings, and they experience minimal trading costs.
An investor in a mutual fund may have to pay more than just the fund’s annual expense ratio in fees. Brokers and investment advisors who stand to gain from granting you access to a mutual fund may levy upfront fees, also known as “loads,” on your account. Load funds are mutual funds that charge investors a large amount of money upfront for the privilege of owning shares.
Furthermore, if you sell your shares in a fund and make a profit, you will have tax obligations. Dividend income is subject to taxation in the year it is received, and capital gains are subject to taxation on the sale of investments held for more than a year.
What is an illustration of a cost-to-income ratio?
Here is some more information about the Stock Fund (NASDAQMUTFUND: DODG.X), managed by Dodge & Cox Investments. In the section labeled “General Information,” you’ll find the expense ratio of 0.52%. The fund returns $5.20 per year for every $1,000 invested.