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Expense Ratio (Definition) – Why You Should Pay Attention When Investing

The ultimate goal of any investment is to make money. So, investors spend quite a bit of time focusing on learning about companies, digging into new investment strategies, and analyzing the market as a whole. But there’s one thing that many investors are missing.

It costs money to make money.

The stock market is an intricate system. To keep that system running, there are regulators, stock exchanges, brokers, and several other entities that devote all of their time, money, and efforts to keeping the system alive.

Financial regulators, brokers, and other professionals charged with keeping the market available to you simply don’t work for free. Their pay has to come from somewhere, and it all trickles down to money being taken out of the end investor’s pocket, just as shipping costs trickle down to the end consumer who purchases groceries at the local grocery store.

Just as paying attention to grocery prices is important to your household’s bottom line, paying attention to the prices you’re charged when you make an investment is important to the bottom line of your investing portfolio.

What Is an Expense Ratio?

The expense ratio is a term used in the investing community to describe the cost of an investment in a way that’s easy to understand. By definition, the expense ratio is the total percentage of assets used for administrative, management, advertising, and all other expenses.

Expense ratios can be calculated at a portfolio level or at a singular investment level. Here’s how expense ratios are calculated:

Single-Stock Expense Ratio

If you’d like to know the expense ratio of a single stock, you simply add up any expenses associated with owning that stock. This includes brokerage fees, regulatory fees, and any other fee that you will pay throughout the purchase or sale of that stock. Now, divide the total cost of the investment by the average value of the investment.

For example, let’s say you own $1,000 of ABC stock. All expenses involved in buying, holding, and selling your shares add up to $10. In this case, you would divide $10 (your total cost) by $1,000 ( the total value of your investment), coming to an expense ratio of 0.01, or 1%.

Fund Expense Ratio

Investments in mutual funds, index funds, and exchange-traded funds (ETFs) also come with fees. In order to calculate the expense ratio of a fund, you would need to divide the fund’s operating expenses by the average dollar value of its assets under management or the underlying investments from which the fund derives value. The result of this calculation is the fund’s expense ratio.

For example, let’s say an ETF has a total of $10 billion in assets under management. The expenses associated with managing these assets come to approximately $100 million per year. To figure out the ETF’s expense ratio, divide $100 million by $10 billion. In this case, the expense ratio will come to 0.01, or 1%.

Portfolio Expense Ratio

Finally, you can calculate the expense ratio of your investments on a portfolio level. This is valuable because it gives you an idea of how much money your investments are costing you as a whole. To calculate your portfolio expense ratio, simply divide the expenses that you are charged across your portfolio by the entire portfolio value.

For example, let’s say your total investing portfolio value averages about $100,000 and you pay about $1,000 per year in expenses. Divide $1,000 (the total cost associated with your portfolio) by $100,000 (the total average value of your portfolio). The result in this case is 0.01 or an expense ratio of 1%.

Important Notes

You’ll notice in all the examples above that you need to divide expenses by average values, but how do you get those average values? Most of the time, investors look at expense ratios from an annual perspective. If that’s what you’re doing, the average value would be based on the average value of the asset, assets under management, or portfolio over the course of a year.

However, you may be inclined to learn about your expense ratios over longer periods of time. What if you want to know what your average expense ratio has been over the past five years or over the life of your portfolio?

No matter what time frame you’re looking into, simply calculate your expense ratio based on the amount of expenses paid within that time period and the average value of assets across that time period.

It’s also important to note that many investors consider expense ratios to only be associated with funds, and only include the fund’s operating cost. In fact, when you search for an expense ratio of a specific fund, published figures often fail to take some expenses into account.

However, failing to calculate expense ratios including all commissions, and failing to calculate these ratios across all types of investments and your portfolio, leaves you relatively blind to what your investments actually cost you. As a result, it is wise to calculate your own expense ratios.

Expenses Involved in Investing

You may not realize it when you click the buy button, but when you invest, you’re also agreeing to pay several different types of fees. Here is a breakdown of the types of fees you’ll be charged:

  • Fund Operating Expenses. It costs money to run a fund. Fund managers must pay to develop, market, and manage the fund. These fees all trickle down to investors and are commonly the only fees included in published expense ratios of funds. However, they are far from the only fees charged when investing in funds.
  • Management and Advisory Fees. If you’re working with a financial advisor, whether it be a robo-advisor or human being, you’re going to pay a fee for your advisor’s services.
  • Transaction Fees. Transaction fees are the fees paid to your broker when you buy or sell stock or other securities. Keep in mind that not all brokers charge fees. In fact, there is a growing trend among online discount brokers who are ditching commissions and transaction fees, making investing more accessible for the average person.
  • Front-End Load Fees. Front-end load fees are a way for fund managers to bake commissions into investments on top of all other fees charged. These are fees that investors pay when they initially invest into a mutual fund, index fund, or ETF.
  • Back-End Load Fees. Back-end load fees are a way for fund managers to double dip on the commissions they add to their operating costs. These commissions are paid when you exit your investment with the fund.
  • Annual Account and Custodial Fees. The technology and personnel used to manage and maintain your investments cost money. These costs are kicked down to the end investor by way of annual account and custodial fees.
  • Regulatory Fees. Finally, regulators like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) need to be paid for the work they do. These fees are added to securities transactions, but are so small that they barely exist.

When determining the expense ratio of any of your investments, all the fees above should be included in your calculations to ensure that you get a comprehensive view.

Expense Ratio Ranges

Expense ratios vary by investment, broker, and a number of other factors. The fact of the matter is that, in the United States, professionals have the right to charge whatever they want for their products and services. As a result, prices vary widely regardless of what product or service you’re looking for — including investments.

So, what is a good expense ratio and what’s a bad one?

That depends on what type of investing you’re doing. If you’re managing your own portfolio, your expense ratio overall should be below 0.5%. Any expense ratio higher than that suggests that you’re overpaying someone somewhere.

When it comes to actively managed portfolios, expense ratios are higher. This is because, when a professional manages your portfolio for you, they will charge a fee for doing so. In most cases, an expense ratio between 0.5% and 1.5% is reasonable, as long as your returns justify the added expense.

However, there are some actively managed portfolios with expense ratios over 1.5%. If that’s the case in your portfolio, you’re definitely overpaying someone, and it’s likely the advisor or team of advisors managing your portfolio.

Why Expense Ratios Are Important

Investing is all about making money, not spending it on expenses. So the core focus should be on making money, not worrying about expenses, right? Isn’t 1.5% — or even 2% — a minimal fee?

Absolutely not!

A 1% difference in the expense ratio in your portfolio could become tens of thousands or even hundreds of thousands of dollars over the life of your investments.

This is because of the power of compound gains. When you earn money through an investment and reinvest that money to earn more, it means that your earnings are compounding, or multiplying. Compound gains make up a vast percentage of the overall returns that you receive through your investing activities.

When you pay fees out of your gains, you’re robbing yourself of some of that compounding power. Instead, your expenses compound.

For example, if you were to invest $25,000 today and an additional $10,000 per year for a period of 40 years with an average annual return of 7%, you would lose more than $500,000 if you were to pay just 1% extra in fees on your investments.

So, 1% really is a lot of money. In fact, a single percent increase in your expense ratio could cost you more than it would to buy two average American homes or 13 average American cars — 1% compounded over 40 years is a whole lot of money!

Pro tip: Have you considered hiring a financial advisor but don’t want to pay the high fees? Enter Vanguard Personal Advisor Services. When you sign up, you’ll work closely with an advisor to create a custom investment plan that can help you meet your financial goals.

Is Working With an Expert Worth a High Expense Ratio?

There’s a natural perception that, when you work with an expert on anything, the outcome is going to be better. For example, if you have a roof leak, you’re most likely going to call a professional roofer to come and patch it up rather than climbing a ladder and doing it yourself. The value in that is knowing that your repair will be done right.

Isn’t the value of working with a professional portfolio manager the fact that you make more money? Don’t the fees charged by these professionals get absorbed by the gains they generate?

The iconic investor Warren Buffett says no.

Buffett has been quoted countless times saying that investors should invest in low-cost index funds rather than paying high-priced wall-street professionals to make your moves for you. In fact, he has explained that not only do these professionals lead to a high expense ratio, but it is extremely rare that they’re capable of outpacing the returns that you would receive if you purchased an unmanaged ETF in the first place.

He’s not lying. CNBC recently published a report that dove into the value of high-cost, actively managed portfolios. The report found that more than 85% of “professional” fund managers were unable to outperform the S&P 500 over the course of 10 years.

You don’t always get what you pay for.

The report by CNBC yields two conclusions. First and foremost, active fund managers are often incapable of providing better returns than low-cost index funds. Moreover, the fees charged by active fund managers are not absorbed into the excess gains, because excess gains are not likely to be achieved consistently.

Is There Any Value in High-Expense Ratio Investments?

There’s value in just about anything. Farmers even see feces as a valuable asset. When it comes to investing, there is little value involved in an investment with a high-expense ratio.

The only value that comes from an actively managed portfolio you’re paying someone else to manage for you is convenience and the peace of mind that comes from outsourcing your money management to a professional. However, as you’ve learned above, when you dig into the details, the peace of mind starts to go out of the window.

How to Reduce Your Portfolio’s Expense Ratio

There are a few ways that you can go about reducing your expense ratio. Some of the most common include:

  • Manage Your Own Investments. By managing your own investments, you cut the expense of having a third party involved completely out of the equation. Keep in mind, this is only an option if you have a detailed knowledge of the market and how to invest successfully.
  • Look to Low-Cost Funds. Buffett swears by low-cost index funds. However, there are plenty of funds, including ETFs and mutual funds, that come with relatively low expense ratios. Investing in these low-cost funds not only decreases your expense ratio, but gives you access to portfolios curated by professionals in the industries, assets, and indexes that you plan to invest in. Just keep in mind that not all funds are created equal. So, it’s important to look at the fund’s performance and expense ratio to make sure you’re getting a good deal.
  • Work With a Discount Broker. Cutting commissions and transaction fees can greatly reduce your overall investing expenses. Brokers like WeBull, Robinhood, and many others are moving toward a fee-free model. So, if you’re paying fees for transactions, your broker hasn’t gotten with the times.

Final Word

Investing is about making money, yes. But it’s also about allowing the money you make to make more money for you, not letting fees eat into your profits. Paying attention to the expense ratio associated with the investments you make will help to ensure that you don’t become a victim of these profit-devastating fees.

It’s always worth the time to dig into the fees you’re charged when you make an investment to ensure that they are reasonable. If you don’t, being oblivious to these expenses could cost you tens of thousands or hundreds of thousands of dollars in the long run.

Joshua Rodriguez has worked in the finance and investing industry for more than a decade. In 2012, he decided he was ready to break free from the 9 to 5 rat race. By 2013, he became his own boss and hasn’t looked back since. Today, Joshua enjoys sharing his experience and expertise with up and comers to help enrich the financial lives of the masses rather than fuel the ongoing economic divide. When he’s not writing, helping up and comers in the freelance industry, and making his own investments and wise financial decisions, Joshua enjoys spending time with his wife, son, daughter, and eight large breed dogs. See what Joshua is up to by following his Twitter or contact him through his website, CNA Finance.

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