If you’ve been investing for a while, chances are you’ve heard of something called an “expense ratio,” a decimal value on an investment fund’s fact sheet that often isn’t given any kind of further explanation. But even if you’re familiar with the term, you may not realize how that number affects your money.
As the name implies, an expense ratio relates to the expenses related to running a fund, including everything from management and marketing to accounting and administrative costs. (A fund is just a pool of money that’s allocated for a specific purpose–in this case, the money comes in from different investors and then is typically invested by a fund manager into a basket of stocks or bonds.) Funds typically charge for their costs as a percentage of the amount of money you invest.
An actively managed fund’s manager may buy or sell shares each day to try to improve returns. But even passive index funds, which generally follow a buy-and-hold strategy and often track a benchmark index (like the S&P-500 stock index), have some overhead as they still require someone to perform periodic maintenance when shareholders add or withdraw money or the index the fund tracks reevaluates its holdings.
A 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. With an expense ratio of 1 percent, $10 of every $1,000 you invest goes to fund costs each year.
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 percent, with a 1 percent expense ratio, you’ll actually see returns of 9 percent.
Since the introduction of index funds, expense ratios have fallen pretty consistently. The average expense ratio is now .48 percent, according to Morningstar’s 2018 fee study. That’s equivalent to about $5 per every $1,000 invested.
But that average doesn’t tell the whole story since it considers both actively and passively managed funds.
For active funds, or those that are continuously managed and curated by investment professionals, average expense ratios fall closer to .67 percent ($6.70 per $1,000). Passive funds, or those that aim to emulate the performance of major indexes, come in lower at .15 percent ($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. What’s more, stock-based index funds, like an S&P 500 fund, have even lower expense ratios than other passive funds, averaging .09 percent, according to the ICI.
While that $5 per $1,000 a year may not seem like much, it can add up over time. Assuming a $100 monthly investment and a (reasonable) 7.5 percent rate of return, the average actively managed fund will cost over $10,000 more than the average passively managed fund over 30 years. And as investment contributions go up, the gap only widens. If you invest $1,000 a month for 30 years, the difference in fees tops $100,000!
Of course, that fee differential doesn’t necessarily mean you should never invest in actively managed funds. If they consistently outperform the passive funds, you could end up with more money over the long term. But there’s no guarantee they will.
Unfortunately, it’s very hard for even the experts to consistently beat the market (and by extension for active funds to outperform passive funds).
In 2018, 64 percent of active funds’ performance lagged behind their S&P 500-stock index benchmark for that year, and things only grow bleaker when looking further back. When examining average annual performance over the past 15 years, nearly 92 percent of actively managed funds fall short of their benchmark, according to S&P Dow Jones Indices.
This means that while select actively managed funds may outperform their benchmarks (and their related index funds) over the short term, less than 10 percent manage to do so successfully over the long term. Although it’s possible you may be able to pick an actively managed fund that outperforms its benchmark consistently, the odds aren’t in the average investor’s favor and decrease every subsequent year.
That’s why an awareness of expense ratios is key. Keeping these fees as low as possible lets more of your money work for you instead of going toward funds’ operating costs.
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.
Once you’ve decided on passive funds with low expense ratios, you have a couple of options: you can research individual funds and then purchase shares through a brokerage, or you can use an investment platform like Acorns, which lets you easily invest in a diversified portfolio of very low-cost exchange-traded funds (ETFs) with exposure to thousands of stocks and bonds.
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