Mutual funds are one of the best ways to invest your money. There’s a mutual fund for almost every investment style and portfolio allocation. They make it easy to diversify your investments across multiple companies’ stocks or bonds to help reduce risk.
For all their benefits, there is a drawback to using mutual funds. Each fund has an expense ratio, which is a type of fee that mutual funds charge.
We’ll go over the factors that determine a typical mutual fund’s expense ratio and how it can impact your investment.
Table of Contents
- What is an Expense Ratio?
- Why Do Mutual Funds Charge Fees?
- What is a Typical Expense Ratio for a Mutual Fund?
- Why Are Expense Ratios Important?
- How Fees Affect Investment Growth Over Time
- What is a Reasonable Expense Ratio?
- Do Mutual Funds and ETFs Charge Other Fees?
What is an Expense Ratio?
An expense ratio is a fee charged by a mutual fund. They are expressed as a percentage of your investment that you pay as a fee each year. For example, a mutual fund with an expense ratio of .5% charges you $5 each year for every $1,000 you have invested.
You don’t get a bill for these fees. Instead, the mutual fund companies bake the cost into the daily changes in the fund’s price. That means you won’t have to worry about making a monthly payment to keep your money invested. It also makes it easy to miss these fees despite their importance.
Why Do Mutual Funds Charge Fees?
Mutual funds charge fees for several reasons. At the most basic level, expense ratios and other fees help mutual funds pay for the costs involved in keeping the fund afloat.
The company managing the fund has to deal with paperwork, handle transactions, and pay fund managers. The companies pass those costs on to investors through expense ratios.
Mutual funds also want to grow their assets under management. Many fund providers advertise their funds to find more investors. And, within certain limits, they pass the costs of promoting a fund to the funds’ shareholders.
What is a Typical Expense Ratio for a Mutual Fund?
The expense ratio of a mutual fund will depend on many factors. These are some of the most important determiners of a fund’s expense ratio:
Active vs. Passive Management
Because they require more effort from fund managers, active mutual funds tend to have higher expense ratios than passive funds.
Funds with a passive management strategy usually aim to track a specific stock index. For example, an S&P 500 index fund hopes to track the movement of the S&P 500 as closely as possible.
The stocks in the S&P 500 don’t change often, so the bulk of the fund managers’ work is dealing with the funds’ investors. They don’t have to do much market research or trading.
Active funds have managers that are trying to execute a specific strategy, usually with hopes of hedging against weak markets or outpacing market gains.
These types of strategies require a lot more work and resources than passive funds do. Fund managers have to be looking for investment opportunities every day and moving money around to make sure they follow the desired plan of action.
Size of the Mutual Fund
The size of a mutual fund can have an impact on its expense ratio. In general, mutual funds with fewer assets under management have higher expense ratios. Mutual funds with more assets can charge a lower percentage.
The difference in cost caused by the size of the fund is due to economies of scale. As the number of investors and the amount invested grows, some costs will increase. For example, larger funds will need more employees capable of handling investor questions.
However, some prices are relatively fixed and change very little as more assets are invested. So as investments grow, fund managers can charge a smaller percentage of each investor’s money to cover these fixed costs.
What the Fund Invests In
Mutual fund expense ratios cover the costs of managing a fund, and costs can vary widely depending on the investments that the fund holds.
Mutual funds that focus on domestic stocks and bonds will likely carry lower expense ratios than funds that invest in foreign businesses, as the cost of foreign investment is higher.
Similarly, funds that use complicated strategies that involve derivatives or other securities that are expensive to trade will charge higher fees.
Mutual fund managers can charge 12b-1 fees as part of their funds’ expense ratios. 12b-1 costs are composed of distribution and marketing and service fees.
The distribution and marketing fee is capped at .75% annually. This portion pays brokers who sell shares in the mutual fund and covers the cost of advertising the fund to potential investors.
The service portion of the fee covers the costs of hiring employees who can help answer questions from the fund’s investors.
Why Are Expense Ratios Important?
Expense ratios are important because they can have a massive effect on your investment’s growth. It might seem obvious, every dollar you pay in fees is a dollar that you don’t have.
The thing that makes expense ratios a big deal is that expenses, like returns, compound over time. Because of this, even a small fee can have a massive impact.
How Fees Affect Investment Growth Over Time
What impact can the difference in the percentage of an expense ratio have on your investment?
Consider this example:
James has $3,000 to invest for his retirement. He puts his money in a mutual fund with an expense ratio of 1%. He adds an extra $250 to his account every month. The fund earns 10% returns each year, minus the 1% expense ratio. After 40 years, James retires and looks at his investment account. He has $1,107,875.60 that he can use during his retirement.
Jane, like James, invests $3,000 in a mutual fund, adding $250 to her investment every month. The only difference is that the mutual fund that Jane chooses has an expense ratio of .5%. If the fund returns the same 10%, minus the .5% expense ratio, after 40 years, Jane will have $1,272,718.17.
By cutting just half a percent from the expense ratio, Jane’s investment will earn almost $165,000 more than James’.
What is a Reasonable Expense Ratio?
Because expense ratios are affected by so many factors, knowing whether an expense ratio is reasonable can be difficult.
A 2018 Morningstar study found that the average expense ratio for mutual funds and ETFs was .48%. The study also noted that fees have been trending downward since 2000.
Active funds charged an average of .67% while passively managed funds charged just .15% on average.
These numbers are averages, so some funds charge higher fees and some that charge lower.
Depending on your investment strategy and goals, you may want to use a fund that charges a higher than average price. Just make sure that if you do, the fund is justifying its costs by performing as you expect.
Because of the massive effect that expense ratios have on returns, many investors are better off opting for the low-fee funds instead of chasing higher returns from expensive funds.
Do Mutual Funds and ETFs Charge Other Fees?
Every mutual fund has an expense ratio that accounts for its annual management fees. But the expense ratio isn’t the only fee funds charge. Many funds add additional fees that can impact your investment returns.
One common type of fee is a sales load. Sales loads are percentage-based commissions charged when you buy or sell shares in a fund. For example, if you buy $1,000 worth of shares in a fund with a 3% load, you’ll pay $30 in load fees.
Funds can have front-end loads (purchase commissions) or back-end loads (sales commissions). Some funds will have both.
Some funds charge purchase fees in addition to or instead of loads. While a purchase fee and front-end load seem similar, there is a difference. The broker that you use to buy or sell the fund receives loads. However, the company that operates the fund receives purchase fees.
On top of loads, some mutual funds charge redemption fees. This fee is a percentage fee charged when you sell shares shortly after you purchase them. The cost is designed to discourage investors from quickly buying and selling shares in the fund. The required holding period to avoid this fee can vary from a few days or weeks to more than a year.
Finally, some funds will charge an account fee if your balance falls below a certain amount. Most funds have a minimum investment amount. If you buy in close to the minimum and the fund loses value, you could wind up below the minimum investment amount, which is what usually triggers these fees.
Expense ratios are a percentage fee that is charged when you invest through a mutual fund. Fund managers use the fees you pay to handle the costs of running the fund. Mutual funds make it easy for you to diversify your investments, so paying the fee is often worth it.
But don’t ignore the impact that expense ratios have on your investment returns. Even a small change in the ratio can have a huge impact on your returns over a long period.
Have you invested in a mutual fund? Has the return on your investment been worth paying the fees? Let us know in the comments below.