An expense ratio (ER) or management expense ratio (MER) is the cost or the amount charged by a mutual fund or an ETF (exchange-traded fund). Funds have to pay for portfolio management, administration, marketing, and distribution, and other expenses. The cost is always expressed as a percentage of the fund’s average net assets (instead of a flat dollar amount).
HUH? An expense ratio measures how much you’ll pay over the course of a year to own a fund. For example, a fund may charge 0.2 percent. That means you’ll pay $20 per year for every $10,000 you have invested in that fund.
Funds can be actively managed (meaning a person or team are actively picking which stocks, bonds, etc are in the portfolio) or passively managed (meaning they mirror the market or existing benchmark like the S&P 500). Actively managed funds cost more because someone is actively trying to beat market returns.
SO WHAT’S LOW COST? A reasonable expense ratio for an actively managed portfolio is about 0.5% to 0.75%, while an expense ratio greater than 1.5% is high. For passive or index funds, the typical ratio is about 0.2% but can be as low as 0.02% or less in some cases. Robo-advisors typically invest in low-cost ETFs with much lower expense ratios, ranging from 0.05% to 0.20% in most cases. Or you can do it yourself! The cheapest option would be to open an account and invest in low cost index funds or ETFs.
WHY IS THIS IMPORTANT? Expense ratios significantly affect a fund’s return and an investor’s profit, especially over time. 1% doesn’t sound like a lot but it is!
Check out our episode with Amanda Holden to learn more about the importance of low cost investments.