Expense ratios can easily make or break your retirement savings.
These numbers, shown as a percentage, represent the amount investors pay for a mutual fund, index fund or ETF on an annual basis. And because that fee is skimmed out of the invested assets, many investors pay it no mind — or fail to realize it exists.
The reality: There’s no getting around investment expenses. But you can work to minimize them, and the first step is knowing what you’re paying — and what’s fair.
Even small fees add up
Over the course of a person’s career, these fees can amount to large sums of cash. Even an expense ratio as small as 0.25% — that’s $2.50 for every $1,000 invested — makes a big difference over time. Here’s how a one-time investment of $100,000 is affected over 30 years:
|Expense Ratios on a $100,000 Investment|
|Total cost of expenses||$51,857||$99,788||$186,876|
|Portfolio value after 30 years||$709,368||$661,437||$574,349|
(Assumes 7% annual return with no further contributions.)
A fund’s expense ratio will be listed in its prospectus and on the fund company’s website, says David Larrabee, director at the CFA Institute, an association of investment professionals.
Your broker or account provider will also typically list the expense ratio on a fund’s information page, which also mentions other details investors want to know, such as the fund’s rating, its past performance and the investments it holds.
The expense ratio varies by investment
In general, you’ll pay the most for mutual funds that are actively managed and that invest in stocks. These mutual funds, known as equity funds, carry an asset-weighted expense ratio of 0.7%, according to the Investment Company Institute. Managed funds that invest in bonds cost less, averaging 0.57%.
Cheaper still are index funds and exchange-traded funds, a form of index fund that trades like a stock. These track an index like the S&P 500 rather than relying on active management. ICI data show equity and bond index funds have an average expense ratio of just 0.11%. (Compare expense ratios for all types of mutual funds.)
There’s good news: Expense ratios have headed down over the last decade or two, says Larrabee, largely due to a growth in assets.
“A lot of the expenses associated with mutual funds are fixed,” Larrabee says. “They include the costs of running the fund — things like accounting fees and fees for the directors — and those don’t change.” With assets growing but costs remaining about the same, expense ratios have dropped.
Consider fees when building your portfolio
Many 401(k) plans have only one or two choices in each fund category. This is one reason most investors benefit from switching to investing in an IRA once they’ve maxed out their 401(k) match; IRAs have a wider range of investment options, making it easier to minimize fees.
That said, no matter where you are investing, you should work to keep costs down, which means selecting index funds where available. In general, if your choice is between a managed mutual fund and an index fund, the index fund is going to have a lower expense ratio — and research shows they stack up to or even beat managed funds in performance.
When choosing between mutual funds that are actively managed, consider not just fees, but other factors, such as the fund manager’s track record and the age and size of the fund (the SEC has a good guide to evaluating mutual funds, as well as a detailed resource on investment expenses).
“Just as you wouldn’t go out and buy the least-expensive car in the lot, there are other factors at play,” Larrabee says.
That is less true of index funds and ETFs, as long as you’re comparing funds that are tracking the same benchmark.
Don’t forget transaction costs
In addition to expense ratios, there are transaction fees — such as commissions or loads — that factor into your overall portfolio expenses. Commissions generally come from stock or ETF trading; loads are tacked on to some mutual funds as a charge to either buy or sell.
Many investors can limit or avoid transaction costs by investing in commission-free ETFs(otherwise, because they’re traded like stocks, ETFs will incur commissions when bought or sold) and selecting no-transaction fee mutual funds.
If you engage in stock trading, you’ll pay commissions, but you can minimize them by choosing a discount broker or one that offers commission-free trading, either as a promotion or on a regular basis, like the mobile app Robinhood.
The bottom line
Expense ratios can pretty easily make a six-figure difference in your portfolio. You shouldn’t select an investment without knowing how much it costs. In most cases, investors can minimize costs by angling their portfolio toward low-cost index funds and ETFs.
This article first appeared in NerdWallet.