Exchange-traded funds (ETFs) and mutual funds charge an expense ratio to shareholders to cover total annual operating expenses. The ETF expense ratio is expressed as a percentage of a fund’s average net assets and can include various operational costs such as:
- Administrative
- Compliance
- Distribution
- Management
- Marketing
- Record-keeping fees
- Shareholder services
The ETF expense ratio, which is calculated annually and disclosed in the fund’s prospectus and shareholder reports, directly reduces the fund’s returns to its shareholders, and, therefore, the value of your investment.
Over the past two decades, fund expenses have trended significantly lower, and now many index ETFs offer expense ratios as low as 0.03% per year. The average expense ratio for all of Vanguard's mutual funds and ETFs is currently 0.09%.
Key Takeaways
- Mutual funds and ETFs charge their shareholders an expense ratio to pay for operations and fund management.
- Higher expense ratios eat into nominal returns for investors.
- Trading securities in one’s portfolio is not included when calculating the expense ratio, and so active funds tend to carry higher expenses than passive ones.
- Over the past decades, fund expense ratios across the board have been trending quite a bit lower.
- Investors have various tools at their disposal to determine expense ratios, including fund prospectuses and news journals.
What's Trending Now?
According to a report published by the Investment Company Institute (ICI) titled "Trends in the Expenses and Fees of Funds, 2021," expense ratios incurred by investors in long-term mutual funds have, on average, declined substantially for more than 25 years. In 1996, equity mutual fund expense ratios averaged 1.04%, falling to 0.47% in 2021. Hybrid funds went from 0.95% in 1996 to 0.57%, and bond funds dropped from 0.84% to 0.39%.
The trend in lower expense ratios can be attributed to a variety of factors, such as money market funds waiving expenses to ensure that net returns remain positive during periods of low interest rates, and target date mutual funds being able to lower expenses due to economies of scale (target date mutual fund assets have increased substantially since 2011).
In addition, expense ratios often vary inversely with fund assets, meaning that as a fund’s assets increase, its fixed costs likely represent a smaller percentage of its net assets; therefore, its expense ratio can correspondingly decrease.
Despite trends indicating an overall decrease in fees across many fund categories, investors should still pay attention to expense ratios: even small differences in fees can have a significant impact on your investment over time.
Even a small difference in expense ratio can cost you a lot of money in the long run.
Understanding Costs and Expense Ratios
The expense ratios for mutual funds generally tend to be higher than those of ETFs. While ETF expense ratios top out at no more than 2.5%, mutual fund costs can be significantly higher. Operating fund costs vary greatly depending on the investment category, investment strategy, and the size of the fund. Those with higher internal costs generally pass on these costs to shareholders through the expense ratio. For instance, If a fund’s assets are small, its expense ratio might be relatively high, because the fund has a restricted asset base from which to meet its expenses.
When looking at funds and costs, compare funds that own similar types of investments. For example, international funds are typically very expensive to operate because they invest in many countries and may have staff all over the world (which equates to higher research expenses and payroll). Large-cap funds, on the other hand, tend to be less expensive to operate. While it is reasonable to compare expense ratios across multiple international funds, it would not make sense to compare the costs of an international fund against a large-cap fund.
When researching investments, there are several ways you can determine the expense ratio of a fund:
- Fund Prospectus: If you are already a shareholder, the prospectus will be mailed or sent electronically to you each year. The expense ratio is typically found under the “Shareholder Fees” heading. You can also view the prospectus on the fund company’s website.
- Financial News Websites: Websites such as Google Finance and Yahoo! Finance have expense ratio information for mutual funds and ETFs. Type in a fund’s ticker symbol to view this information.
- Fund Screeners: Many ETF and mutual fund screeners are available online. You can search by category or group (i.e., equity, bond, money market, international) and compare expense ratios across similar investments. FINRA’s Mutual Fund Expense Analyzer, for example, allows you to compare up to three mutual funds (or ETFs) or the share classes of the same mutual fund. The tool estimates the value of the funds and the impact of fees and expenses on your investment.
- News Journals: Print newspapers, such as Investor’s Business Daily and The Wall Street Journal print information regarding funds, including expense ratios.
How Rates Affect Investments
To see how expense ratios can affect your investments over time, let’s compare the returns of several hypothetical investments that differ only in expense ratio. The following table depicts the returns on a $10,000 initial investment, assuming an average annualized gain of 10%, with different expense ratios (0.5%, 1%, 1.5%, 2%, and 2.5%):
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As the table illustrates, even a small difference in expense ratio can cost you a lot of money in the long run. If you invested $10,000 in the fund with a 2.5% expense ratio, the value of your fund would be $51,524 after 20 years. Had you instead invested your $10,000 in the fund with a lower expense ratio, such as the one at 0.5%, then your investment would be worth $64,122 after two decades. This is a 24% improvement over the more expensive fund.
Keep in mind, this hypothetical example examines funds whose only differences are the expense ratios: all other variables, including initial investment and annualized gains, remain constant (for the example, we must assume identical taxation as well). While two funds are not likely to have the exact same performance over a 20-year period, the table illustrates the effects that small changes in expense ratio can have on your long-term returns.
What Is a Good Mutual Fund Expense Ratio?
It can depend on the type of fund. Equity mutual fund expense ratios average 0.47%, according to 2021 data from the Investment Company Institute. Hybrid funds average 0.57% and bond funds average 0.39%. A mutual fund expense ratio that is at or below the average is ideal.
Do Funds or ETFs Have Higher Expense Ratios?
Generally, mutual funds have higher expense ratios than exchange-traded funds (ETFs). Equity mutual funds expense ratiosaverage 0.47% in 2021. By comparison, index equity ETFs were 0.16% in 2021, according to the Investment Company Institute, down from 0.34% in 2009.
How Often Is an Expense Ratio Charged?
Mutual fund and ETF expense ratios are calculated and charged annually. As a result of this, a high expense ratio can have a big impact on returns over the long run.
The Bottom Line
While it's important, a fund’s expense ratio is not the only consideration when analyzing and comparing fund investments. There are numerous avenues to purchase mutual funds, including online, and investors must also consider a variety of factors before buying, like each fund's individual:
- Sales charges
- Taxes
- Age and size
- Risks and volatility
- Recent changes in operations (for example, has the fund’s investment adviser changed?)
- Impact on your portfolio diversification
It should be noted that a fund’s expense ratio represents your cost of owning the fund—not purchasing or redeeming the fund (sales loads). Any initial or deferred sales charges, transaction fees, or brokerage charges are not included in the expense ratio. All of these factors should be taken into consideration prior to making any investment decisions. With research, you can find funds that meet your goals and objectives while leaving more money in your portfolio.
Correction—Nov. 10, 2022: This article has been updated from a previous version to correct the final values of the hypothetical portfolios.
