Mutual fund and ETF expense ratios: A guide

When investing in mutual funds, ETFs or other investment funds, one factor to consider is the fund’s expense ratio. While expense ratios tend to be small numbers – sometimes less than a percentage point – they can make a big difference in how much of a return on investment (ROI) you’ll see over time.

Understanding what expense ratios are, how they’re calculated and what a good expense ratio is can help you find the right investment vehicle to help you meet your long-term goals.

What are expense ratios?

The expense ratio represents the annual fee you pay as a percentage of your total investment to the company managing the fund you’re invested in. This fee covers the fund’s operating expenses, such as administrative costs, management fees and marketing costs.

Expense ratios are typically expressed as a percentage, often ranging from 0% to 1%. For example, if a fund has an expense ratio of 0.4%, you would calculate the fee by multiplying your investment amount by 0.004 (the decimal equivalent of 0.4%). So, if you had $1,000 invested, your annual fee would be $4.

Funds with more assets may have lower expense ratios compared to smaller funds. This is because larger funds with more clients and assets may be able to take advantage of economies of scale. This allows them to distribute their costs among a larger pool of investors without seeing a significant rise in operating expenses.

ETFs and mutual funds that largely follow a stock index like the Nasdaq or S&P 500 (also known as index funds), may require less maintenance and therefore may have lower fees. If you come across a fund that focuses on a specialized niche – like values-based investing – it may have higher expenses, which can in turn increase the fund’s expense ratio.

How do you calculate a fund’s total expense ratio?

A fund calculates its expense ratio by dividing its annual operating expenses by its total assets.

So if a fund has $100 million in assets and its annual operating expenses are $1 million, its expense ratio would be 1%.

Expense ratios vs. management fees: What’s the difference?

While reviewing fund options, you may see a line item that specifies management fees. These fees are usually a part, but not all, of the fund’s total expense ratio.

Because of that, it may be helpful to look at a fund’s management fees in conjunction with its expense ratio.

A fund’s management fees is the amount paid to the fund manager (or the overall company) for managing the investments. It may cover portfolio management, investment selection and strategy execution.

The fund’s expense ratio signifies the total cost of owning the fund, and it includes management fees along with administrative costs, operating expenses, marketing costs and other operational expenses. 

Why does a fund’s expense ratio matter?

While paying a 10th of a percent may not seem like a lot, it can make a difference when considering the long-term value of an investment.

A fund’s expense ratio directly impacts your ROI because expenses are directed from the fund’s assets. They reduce your actual investment return and are also charged regardless of fund performance.

It’s also important to note that their impact will compound over time, so if you’re looking at it with a one-year view, it may not seem that meaningful. Over a 20-year period, though, you may see a much more substantial impact.

How do expense ratios affect your return on investment

Let’s say, you make investment contributions of $5,000 annually into a mutual fund for 20 years. Assuming a total investment of $100,000 over the 20-year period, and assuming the fund has a 6% annual return, here’s a look at how your ROI would be impacted by five different expense ratios. 

As you can see, a 0.8% difference in the expense ratio adds up to more than $17,000 in lost returns.

Should expense ratios be the only cost to consider?

Of course, the expense ratio isn’t the only consideration. If a fund has a higher annual rate of return and a higher expense ratio, it may still make more sense to invest in that fund.

Let’s say you hold shares in a fund with a 7% annual rate of return, here’s how five different expense ratios would impact the investment’s return. 

Even with a 0.8% expense ratio, your future investment would be worth $204,584 or roughly $5,000 more than a fund with a 6% rate of return and 0% expense ratio.

The challenge for investors is to balance the potential for return against the expense ratio to get the best long-term return on an investment.

What is considered a good expense ratio for mutual funds and ETFs?

Over the past few decades, expense ratios have fallen considerably for some funds.

According to a report from the Investment Company Institute, the expense ratios for equity mutual funds have dropped from an average of 1.04% in 1996 to 0.42% in 2023. Similarly, the average expense ratio for bond mutual funds has dropped from 0.84% in 1996 to 0.37% in 2023.

There has also been growth in the number of low-cost ETFs available to consumers in the last few decades.

While there are plenty of low-cost fund options to consider, deciding if a fund has an expense ratio that meets your needs will also involve taking into account the potential ROI.

The bottom line

Understanding how expense ratios work can help you select the investment funds that can provide the greatest ROI. However, they shouldn’t be all you look at when deciding if a fund is worth investing in. A fund’s annual rate of return, management team – particularly if it’s an actively managed fund – and other factors should also be carefully considered.

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