Expense ratio – it sounds technical doesn’t it? Even as a finance professional, I hear the term and I don’t even want to dig into it because it sounds complex, detailed, and most importantly…boring! But truthfully, the expense ratio definition isn’t difficult. And, if you don’t understand it and what impact it has on your investments, it could very easily cost you millions of dollars over your lifetime.
What Is An Expense Ratio?
Let’s not delay this. We’ll just jump right into it.
What is an expense ratio?
Put simply, an expense ratio is the annual fee that an investment fund charges the shareholder. This fee is to cover all the costs of managing the funds – the employees, the building, the transaction costs, the office parties, etc. Usually, it’s expressed as a percent of your overall fund investment.
Here are some examples of mutual funds with expense ratios:
First Trust/Confluence Small Cap Val A (FOVAX) = 1.6%
Northern Small Cap Value Fund (NOSGX) = 1.0%
- Fidelity Emerging Asia Fund (FSEAX) = 1.13%
To hammer home the point (in case it’s still unclear what an expense ratio is), let’s say you have $1,000 invested in the Northern Small Cap Value Fund. The expense ratio is 1.0%. So, every year, this fund will charge you 1%, or $10, for investing in their fund (this of course is in the hopes of much greater returns from the fund!).
Doesn’t seem like a huge amount, but (as we’ll discuss later in this article) it can make a HUGE difference over the course of a few decades!!
The Debate Between Managed Funds and Index Funds
You’ve probably heard of index funds. Is that the same as a mutual fund? Is it a managed fund?
Time to clear up the confusion with all these terms. 🙂
A mutual fund is an investment in many different stocks, but all in one fund. Mutual funds can focus on a particular category of spend (like medical supplies), region (like an Asia fund), a particular index (like the S&P 500), or some other conglomerate of investments that make sense to group together. It really is up to the imagination of the mutual fund creator.
The point is, a mutual fund is just an investment tool you can use to invest in many different stocks, but all in one place AND at a reasonable price.
Related: How Do Stock Brokers Make Money?
What is an Index Fund?
We actually eluded to this one in the above explanation.
An index fund is actually a type of mutual fund, but it’s not actively managed. It’s just set up to follow a particular index – like the Dow Jones fund, the Nasdaq, or the S&P 500 (and there are others, but these are the most well-known). These indexes follow certain companies. They rarely change from month to month, or even year to year.
The cost of these funds are typically quite low because once they’re set up, there’s really nothing more for the fund to do! It just keeps investing in those certain companies that are in the index.
What is a Managed Fund?
When someone says they are investing in mutual funds, they typically aren’t investing in index funds. Rather, they are invested in managed funds.
Dave Ramsey recommends managed funds, and here’s the logic:
- managed funds invest in a particular category (our example above was medical supplies)
- the fund may invest in say, 30 different stocks
- the employees then continually review the products, the management of the various firms, the financial security of the companies, etc.
- since they know everything there is to know about the category, they’ll make all the right moves and earn more than the general stock market
- sure, there’s a higher fee for actively managing your investments, but they’ll (in theory) earn more than enough to cover those fees and still beat the market
Related: Investing the Warren Buffett Way
Do Managed Funds Really Beat Index Funds?
Managed funds are analyzed and reviewed by many smart analysts that work for the fund. They often do yield slightly better returns than the overall market…but what about after those fees? Do they still earn more than the stock market as a whole.
I’ve done the analysis before (want to read it? Here’s the post — “Can Your Mutual Funds Beat the Stock Market?“).
In summary, I reviewed 7 funds that had a monumental decade between 1988 and 1997. Then, I took a look at how well they did in the two decades that followed.
How many actually continued to beat the overall stock market (ie. index funds), even after all the fees?
Out of the 7 funds, only 2 of them beat the general stock market in each of the following decades…and just by the skin of their teeth too! So not even half continue to outperform the market! I’d have a better chance throwing darts at a listing of funds vs. making my decision based on the winners of today!
So yes, some mutual funds beat the stock market for a few years, but basically none of them do it consistently year in and year out.
All in all, it appears that managed mutual funds don’t make any more money than index funds that just follow the overall market.
The Expense Ratios of Managed Funds vs. Index Funds
According to Investopedia, managed funds have an average expense ratio of approximately 1.0%. Some are higher, some are lower, but on average, that’s what you can expect to pay for a well-known managed mutual fund.
The expense ratios of index funds are much lower since they’re hardly managed at all. They’re typically below 0.2%, and can be as low as 0.02%. I personally invest in VFIAX, which is the Vanguard 500 Index Fund Admiral Shares. It has an expense ratio of just 0.04%.
The Insane Impact of Expense Ratios Over Time
Here’s the big question:
If managed funds and index funds earn the same amount, but managed funds charge fees of 1.0% vs. the 0.04% of index funds, how big of a difference does that really make??
Since my entire article hinges around this question, you can probably bet that it’s going to make a BIG difference!
Check this out!
And for all you number nerds out there (like me!), here’s the detailed table!
A managed fee of 1.0% vs. an index fund fee of 0.04% could make a $2 million difference in your investments! Instead of earning $7.4M in your retirement fund, you would only get up to $5.2M. That’s a MASSIVE difference!
Do You Care About Expense Ratios Now? What Will You Do?
Had you heard of expense ratios before this article? Did you have any idea that such a small fee could make such a HUGE difference??
It’s time to take a look at your investments. If you have high expense ratios and your earnings are average when compared to the overall stock market, it might be time for a switch!!
What do you invest in? What are your expense ratios??
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.