How to understand mutual fund expense ratios
The expense ratio of a mutual fund is the percentage of your investment that goes toward fees. It can be found in the fund’s prospectus. The expense ratio is one of the key details about a mutual fund that you can find on most websites and brokerage platforms where you’d purchase one.
The expense ratio is the sum total of management fees, administrative costs, and other annual fees—such as the 12b-1 fee—that some funds charge. It does not include one-time fees, such as sales loads brokerage commissions, or redemption and transfer fees.
Key Points
- Mutual fund expense ratios reflect the percentage of your investment that goes toward fees.
- Expense ratios vary widely, with index funds typically charging lower fees.
- Certain tools can help you compare the expense ratios of different funds.
Comparing mutual fund expense ratios
No one can predict future returns on a given fund. “Past performance does not indicate future results,” as the boilerplate disclaimers say. But the fees charged by the mutual fund are known. They come out on a regular basis, regardless of how the fund performs, and can vary widely from fund to fund. That’s why it’s important to examine the fees charged by a given fund before you buy.
One reason for the wide discrepancy in fees is that some funds are actively managed, meaning they have a portfolio manager and team of analysts who actively research, select, buy, and sell securities in the portfolio. For such funds, the management fee is by far the largest component of the expense ratio.
Other funds simply invest according to an index that covers an entire market (e.g., the S&P 500), or a market sector, such as U.S. technology companies. Index funds typically have much lower expense ratios. For example, in 2021, the average expense ratio of actively managed equity mutual funds was 0.68%, versus just 0.06% for equity index funds.
Is a higher expense ratio worth it?
Fees aren’t the entire story when it comes to mutual funds. You may be willing to pay more for a fund managed by a person or team that you believe understands the markets. Or you may be willing to pay a higher 12b-1 fee if you’re buying the fund on a platform that offers research, support, and guidance of real value to you.
If you’re buying a fund with a high management fee, you are essentially paying for alpha, or the fund’s ability to beat the broader market. But beware—a number of studies have concluded that, in a typical year, most funds fail to outperform the broader market. Regardless of whether the fund beats the market in a given year, you’ll have to keep paying the fund’s annual expense ratio.
The upshot? It’s all about your objectives. A straightforward index fund will have an ultra-low expense ratio, but its aim is to mimic the risk and return profile of the underlying index. A more exotic fund—one with a hedging strategy, a leveraged strategy, or one that relies on deep, proprietary research—will cost more to maintain.
Use tools to analyze and compare
It’s important to compare apples to apples to understand if a fund is charging too much. When you compare, look at funds in terms of asset class, market segment, geographic focus, and strategy.
This is where a tool such as FINRA’s Fund Analyzer can come in handy. The tool allows you to compare a fund’s expense ratio to the broader mutual fund marketplace, and also to the fund’s direct competitors—i.e., those investing in the same assets, sectors, and/or regions, and using the same strategies. Alternatively, most online brokers offer account holders a free suite of analysis and comparison tools. Once your research is complete, making a trade is usually a click or two away. And most will allow you to set up recurring transactions.
The bottom line
All funds cost money to operate. Some cost more; some cost less. But they all publish their cost structures in the prospectus.
By determining which services and expertise are worth the cost, and comparing the costs of the funds you’re considering, you can make an informed decision about the mutual funds you buy.