A High Expense Ratio Can Eat Up Your Investing Profits. Here’s a Good Rule of Thumb to Follow

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Mutual funds and ETFs are some of the most popular long-term investment tools. You may even have some in your retirement account.

But what you may not realize is that each year a percentage of your investment goes toward a fee known as an expense ratio.

Whatever you invest in, it is always important to know what fees you pay. And given the popularity of mutual funds and ETFs, many of us pay an expense ratio out of our portfolios every year. In this article, you’ll learn what an expense ratio is, why it’s important, and how to spot a good expense ratio when you see one.

What is an expense ratio?

An expense ratio is a fee charged to investors by a mutual fund or exchange-traded fund (ETF). This fee covers costs associated with administration, portfolio management, marketing, and more. These fees are usually percentage-based and represent an investor’s annual expense.

An expense ratio “helps inform investors what portion of the price of the ETF or mutual fund they’ve purchased is spent on maintenance and other costs,” it said. Bill Van SantSenior Vice President and Managing Director at Girard Investment Services.

The expense ratio an investor pays for a fund is independent of any commissions or other transaction costs he pays to invest. While transaction costs represent one-time costs when you buy or sell an investment, the expense ratio applies every year.

How does an expense ratio work?

In most cases, an expense ratio is the total cost of running a fund divided by the fund’s assets. The higher the operating costs, the higher the expense ratio. Therefore, actively managed funds often have higher expense ratios. Actively managed funds are managed by a human rather than a computer.

Pro tip

Check the expense ratio of a mutual fund or ETF before investing. Quickly calculate how much you pay in fees each year based on how much you plan to invest.

As an individual investor, the amount you pay each year is a percentage of the amount you invested. Suppose an index fund has an expense ratio of 0.5% and you have $10,000 invested in the fund. You would pay about $50 a year in operating expenses.

You will not be billed for your share of the fund’s expense ratio. Instead, the amount is deducted from your investment return.

What is a good expense ratio?

tThe asset-weighted average expense ratio is 0.41%, according to Morningstar data for 2020, down from 0.44% last year. A good rule of thumb is that anything below 0.2% is considered a low rate and anything above 1% is considered high by many experts.

The higher the expense ratio, the more it will eat into your returns. Check the costs before investing.

One of the main factors influencing a fund’s expense ratio is whether it is actively or passively managed. An actively managed fund has a fund manager who regularly buys and sells assets with the aim of beating the market. A passively managed fund, on the other hand, usually tracks the performance of a particular index or market segment. These funds are called index funds.

Because active funds require more hands-on work from the fund manager, they also have higher average expense ratios than their passive counterparts. In fact, that same Morningstar data showed that the average expense ratio for active funds in 2020 was 0.62%, while the average for passive funds was just 0.12%.

Why is it important to understand expense ratios?

When you buy a pooled investment, you pay for a service. And just as you would expect the price of any other service you receive, it’s important to understand how much you pay in mutual funds or ETF fees each year.

“You wouldn’t go to a personal trainer without asking how much they charge, would you?” early Gabi Slemera Chartered Financial Analyst and the founder of Finasana, an online money management platform.

The expense ratio you pay to invest in a particular fund is the percentage of your investment that you must relinquish to the fund company each year. These fees eat into your returns, and when you’re talking about long-term investments, such as pre-retirement, expense ratios can be in the tens of thousands of dollars.

“Fees are very confusing, some claim on purpose,” Slemer said. “The expense ratios are expressed in percentage points, which can sound quite low to many people. 1 to 2%? That’s nothing. Well, when you consider that your return may only be 10%, 2% is actually 20% of your total return. Put another way, if you make 10% on $1,000, that’s $100. If you pay an expense ratio of 2%, you owe $20, meaning your actual return was only 8%, or $80.

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