Why Is a Mutual Fund’s Expense Ratio Important to Investors?

Expense ratios are among a relatively short list of costs—like mortgages or rent, food, and utilities—shared by a wide swath of Americans since a majority of households have money in mutual funds. The ratio is the percentage of fund assets that cover operational expenses, including management fees, administrative costs, and other operating expenses.

The ratio is crucial for investors as it directly impacts the net return on their investments. A higher expense ratio can significantly erode returns over time, making it a critical factor to consider when evaluating and selecting mutual funds. Comparing expense ratios can help you make more informed decisions, potentially helping you find funds that offer competitive returns while having lower costs.

Understanding the Expense Ratio

The mutual fund expense ratio is the percentage of a fund’s assets that pay for administrative, management, and other expenses. It’s calculated by dividing the total of these expenses by the fund’s average assets under management (AUM) over a specific period, typically annually. This ratio provides investors with a clear understanding of how much of the fund’s assets are being consumed by costs as opposed to being invested on their behalf. The formula for the expense ratio is as follows:

$Expense Ratio = (Total Fund Operating Expenses)/(Average AUM)$ExpenseRatio=(TotalFundOperatingExpenses)/(AverageAUM)

There are three main fees covered by the expense ratio. First are management fees. These are paid out of the fund assets to the fund’s investment advisor to manage the portfolio of the mutual fund, including making decisions about which securities to buy and sell. Management fees tend to be the largest part of the expense ratio. This includes the salaries of mutual fund managers whose pay has increased over time (the average in recent years, with a lot variation, is just over $2 million).

Next are administrative costs associated with the fund’s day-to-day operations outside trading securities. These include record keeping, customer service, account maintenance, printing and mailing fund reports and prospectuses, maintaining an internet platform for shareholders to access all the information they need, and other services.

Last are other operating expenses. This includes all other costs for the fund, such as auditing and legal and trustee services. There are also 12b-1 fees intended to cover distribution expenses. They are meant to market and grow the fund’s assets.

The expense ratio does not include sales loads or brokerage costs—these are extra for you, if they apply. However, it does include most operational costs. A lower expense ratio is generally preferable for investors, as it means less of the fund’s assets are being used for operational expenses, potentially leading to higher net returns for investors. It’s a critical metric for comparing the risks and rewards of different mutual funds.

Importance of the Expense Ratio in Mutual Fund Investing

The expense ratio directly affects returns. A higher expense ratio means a larger part of the fund’s assets is used for costs, which directly reduces the fund’s net return to investors.

Over time, even small differences in expense ratios can lead to significant changes in your portfolio because of the mathematics of compounding. A fund with a lower expense ratio allows more of your returns to be reinvested, generating more on those reinvested earnings in the future. This effect becomes even more pronounced over longer time horizons.

Let’s make this more concrete. The average annual return for mutual funds over the last two decades is roughly 12%. The chart below shows the effect of ongoing expense ratios of 1.0%, 0.5%, and 0.15% on a $100,000 investment portfolio growing 12% annually over 30 years. As the investment portfolio grows, the fees you pay also increase. After 10 years, the difference in returns behind the highest and lowest fees below is about $22,500. After 30 years, it’s near $600,000.

While the expense ratio is important, you should weigh it against other factors like overall fund performance and management quality. Some funds with higher expense ratios have superior management, leading to better net performance despite higher costs. Nonetheless, lower-cost funds tend to outperform higher-cost funds when examining broad fund categories over long periods.

It’s best to compare expense ratios among similar funds and consider them along with performance history, management quality, and investment strategy. Investors planning for the long term should account for expense ratios as one of the few fund components they can control directly.

Example of Different Expense Ratios

Imagine two mutual funds, Fund A and Fund B, each with an initial investment of $10,000. Both funds achieve an average annual gross return of 8.0% before expenses, but they have different expense ratios. Fund A has an expense ratio of 0.5%, while Fund B has an expense ratio of 1.0%.

Hence, for Fund A, the net annual return is 8.0% – 0.5% = 7.5%.

Fund B’s net annual return is 8% – 1.0% = 7.0%.

After 20 years, assuming no commissions or taxes, the investment returns of Fund A and B are notably different.

With an expense ratio of 0.5%, Fund A would grow to $42,478.51.

With an expense ratio of 1.0%, Fund B would grow to $38,696.84.

A 0.5% difference in expense ratios resulted in Fund A outperforming Fund B by $3,781.67 over 20 years. This example illustrates how even seemingly minor expense ratio differences can impact mutual fund investments’ long-term growth.

Comparing Expense Ratios

A lower expense ratio can make even more of a difference for investment strategies where the margins between success and underperformance are slim. This is particularly important when operating in challenging market conditions or during periods of lower returns, as the effects of a high expense ratio can be magnified. At such times, every percentage point becomes critical, and the drag created by higher expenses can hinder you from capturing the returns you need to meet your long-term financial goals.

In recent years, the U.S. Securities and Exchange Commission has tightened and revised its regulations to increase transparency in the mutual fund industry. These regulations require funds to provide clearer and more details about their fees, performance, and risks, making it easier for investors to compare expense ratios across different funds. This increased transparency has come at a time when investors already have far more information about their own and other funds through online platforms. Both of these trends have led to a greater awareness among investors about the comparative cost of mutual funds and have prompted them to question what services they are receiving in exchange for the fees they pay. It’s a crucial part of the due diligence when reviewing any mutual fund prospects.

Given these and other industry changes, mutual fund fees have dramatically declined across various fund categories. In 1996, equity mutual funds had an asset-weighted average expense ratio of 1.04%, which has dropped to 0.42% in 2023. Similarly, bond fund fees have fallen from 0.84% in 1996 to 0.37% in 2023.

This trend extends to target-date funds, the most popular choice among investors selecting mutual funds for their 401(k) plans. These funds are actively managed to adjust their portfolios to become more conservative as investors approach retirement. In 2008, the asset-weighted average fee for target-date funds was 0.67%, but by 2023, it was 0.32%. Index funds also had a drop. The asset-weighted average fee for equity index funds in 1996 was 0.27%, while bond index funds had an average fee of 0.20%. By 2023, both equity and bond index funds had their fees drop to 0.05%.

When evaluating mutual fund fees, you need to consider the fund’s category, investment strategy, and historical performance. Lower fees are generally preferred since they allow more of your money to grow over time, but it’s crucial to strike a balance between cost and the potential for returns. Expense ratios should not be the sole criterion when selecting a mutual fund, though they should be a major one.

Factors Influencing Expense Ratios

Why are mutual fund fees different? Several major elements influence the expense ratio:

• Economies of scale: Mutual funds with large AUMs can spread their fixed costs over a larger asset base, often reducing the expense ratio per dollar invested.
• Investment strategy: Actively managed funds typically have higher expense ratios. Portfolio managers’ and research analysts’ expertise is needed to select securities, increasing costs.
• Fund management and efficiency: A fund’s operational efficiency, including administrative practices and the technological infrastructure for managing the fund, can also affect its expense ratio. More efficient operations have lower costs. In addition, the range and type of services offered to investors, such as customer support, financial advice, and the provision of regular reports, can increase these costs and, therefore, the expense ratio.
• Fund type: Funds that invest in specialized sectors or international markets tend to have higher expense ratios because of the increased research costs and the complexities of investing in foreign markets. Also, equity funds generally have higher expense ratios than fixed-income funds, reflecting the higher costs associated with researching and selecting stocks.
• Compliance with laws and regulations: Funds are subject to laws and regulations that can vary significantly depending on the jurisdiction and the fund’s investment focus. The costs associated with meeting these requirements can impact the expense ratio.

Finding Mutual Funds with Low Expense Ratios

Identifying mutual funds with low expense ratios is important for those looking to maximize their returns and minimize the impact of fees on their investments. There are several ways to find these funds:

• Use financial platforms and research websites to filter and sort mutual funds by the expense ratio. This can quickly help you find funds that meet your cost criteria. The Financial Industry Regulatory Authority has an excellent fund analyzer page that’s user-friendly and comprehensive.
• Look for mutual fund families known for their low-cost investment options. However, some funds may use passive investment management strategies instead of active ones.
• Review each mutual fund’s prospectus, which details its expense ratio and other critical information.

Keep in mind that expense ratios can vary significantly across different asset classes. For example, international and specialty funds often have higher expenses than domestic equity funds.

In addition, larger funds can sometimes afford to charge lower expense ratios because of economies of scale, but this isn’t always the case. A fund’s management and operational efficiency can also play a role in determining its expense ratio.

By researching and comparing expense ratios, considering the investment strategy, and understanding the factors influencing fund costs, you can find funds that balance competitive performance and lower costs.

Balancing Expense Ratio and Fund Performance

When selecting mutual funds, the expense ratio and fund performance should be reviewed along with your investment goals and risk tolerance. Lower expense ratios are often more important for long-term investors, as the compound interest effect of costs can be significant over decades.

If you’re seeking exposure to specific strategies or asset classes where active management might add value, it could be prudent to opt for funds with slightly higher expense ratios when they have demonstrated superior performance, even accounting for higher fees. The point is to look at your overall potential returns, not just the expense ratio.

Investors’ Average Fund Costs by Asset-Weighted Average Fees
Asset-Weighted Average Fees (%)	2023
U.S. equity (overall)	0.42
Growth equity	0.61
Sector equity	0.66
Value equity	0.55
International equity	0.56
Investment grade bonds	0.27
Municipal bonds	0.45
Government bonds	0.27
Index equity	0.05
Target date	0.30

Beyond the expense ratio, you should also review other costs associated with the fund, such as sales loads or redemption fees, to understand the total cost of ownership. In addition, while focusing on costs and performance, don’t compromise on diversification. A well-diversified portfolio can mitigate risk and contribute to overall investment success.

What Makes Up a Mutual Fund’s Expense Ratio?

Set by a contract between the fund’s board of directors and its advisors, it comprises fees and expenses for managing and operating the fund. These are bundled into a single percentage representing the fund’s annual costs as part of its assets. These include management fees, administrative costs, and other expenses.

Is It Better To Invest in Actively Managed Funds Over Passive Index Funds?

In general, this hasn’t been the case. Passive index funds now make up the majority of the market’s AUM. You should check specific funds and their performance since there are actively managed funds doing well. However, S&P Dow Jones Indices’s SPIVA Scorecard has for years made sport of showing which actively managed funds have underperformed the S&P 500, categorized by AUM, size of companies invested in, what kind of securities they have, and where they are based geographically. In a sense, this returns mutual funds to their roots when they started their modern growth in the 1970s. The first mutual funds passively invested in the S&P 500, responding to a movement among financial commentators at the time that argued most investors are better off passively investing, not trying to pick winning stocks and bonds. A half-century later, many advisors are repeating this advice.

Why Are Expense Ratios for Exchange-Traded Funds (ETFs) Cheaper Than Mutual Funds?

ETFs were introduced in the early 1990s in part to counter higher-cost mutual funds. That said, fees for both ETFs and mutual funds have gone down significantly since then, and it’s not always the case that an ETF will be cheaper than a comparable mutual fund. Nevertheless, mutual funds generally have higher expense ratios since they tend to have more active management, where fund managers frequently buy and sell securities, requiring more extensive research and other fees. By contrast, ETFs often have lower expense ratios as they are typically passively managed, tracking specific indexes like the S&P 500, or specific sectors, which reduces management and transaction costs. Additionally, ETFs incur fewer brokerage fees because they are traded like stocks on an exchange, making them a more cost-effective choice for investors, particularly those interested in passive investment strategies.

The Bottom Line

Mutual funds’ expense ratios are crucial in deciding on a mutual fund because they directly impact the net returns you receive. A lower expense ratio means a smaller portion of the fund’s assets is used to cover operational costs, allowing more of your capital to remain invested and compound over time.

This compounding can result in significantly higher returns, especially in the long term. By carefully considering and comparing expense ratios, you can select more cost-efficient funds, potentially enhancing your returns and helping you achieve your financial goals. The importance of expense ratios underscores the need for transparency and efficiency in fund management.