[Note: For this article, we will use the terms mutual fund, ETF, and fund interchangeably. Please note the website disclosure statement]
Welcome back to another journey. Today, we will be taking a short stroll to learn about investment expense ratios, or in other words, what your investments cost you! After all, nothing is free 😉
As we learned in the previous article, funds have expenses associated with them. Unfortunately, most people often miss this hidden cost when looking at their 401(k) or IRA accounts, as I learned through working finance industry. But if there is a cost, how does it work, affect your money, and does it matter? So, without further ado, let’s demystify fund expense ratios.
How Expense Ratios Work
To better understand why there is a cost for funds, we need to establish what mutual funds and ETFs are: Companies seeking a profit. That profit is the performance you see when looking at a fund’s return figures or performance history. Like all companies, costs are associated with running funds. These costs span from the rent and wages paid to mimicking the index they follow (or are trying to beat). [Which should you choose, indexed or actively run funds? Check out this article!]
Now an expense ratio is something you never see directly, hence why it is hidden. Because the expense ratio is the daily and yearly cost deducted from a fund, all investors ever see is the fund’s net profit or loss when looking at charts or returns.
With funds, there are three things that matter: The investments owned, the performance of those investments, and the costs to run the fund. Now, the investments owned and the costs to manage a fund impact its performance directly. Thus, by selecting a fund with the investments you desire and monitoring the costs, you have a better chance of controlling the performance!
How do we compare funds, though, when they all hold different investments, incur different costs, and vary in size? I’m glad you asked!
Because of this size difference, listing the actual cost of a fund would be unhelpful at best; this would be like comparing the costs of a big box store to that of a mom-and-pop shop. As a result, the best way to measure costs is to factor in the size of the fund. This is done by dividing the costs by the number of investments held by the fund. (When we say size, we are referring to assets the fund holds, i.e., the investments themselves)
Expense Ratio = Costs / Assets
Why not use sales divided by costs, though, as you would with a traditional business to measure efficiency? The answer is because mutual funds operate differently and are used to grow/preserve investor money. For example, when a mutual fund doubles in size, an investor’s money doubles in size. Hence, by seeing how much it costs to manage a fund’s assets, we see how efficient the fund is at managing money in the pursuit of making a buck!
Calculating an Expense Ratio:
•Fund ABC has $100,000,000 in assets (the investments they manage and hold)
•Fund ABC has $100,000 in costs to run the fund
Thus $100,000 / $100,000,000 = 0.001. Additionally expense ratios are expressed as a percent, so in our example we would take 0.001 * 100 = 0.1%.
We now have a standard unit to measure funds with, woo-hoo!
How it affects your money
So you might be wondering how does an expense ratio for a fund affect my money? Simply put, if two mutual funds have identical investments and strategies, the lower-cost fund should make more or lose less. This is because the middle man’s cut is less, so you get to enjoy more of the gain or incur fewer losses. (For mutual funds, the middle man is the fund’s manager)
Does this always apply? With index funds, this outperformance is more likely to occur than with actively run funds. This is because index funds try to mimic the same thing; for active funds, one may be luckier or have a more skilled manager.
Recapping what we discussed earlier, the three important factors in evaluating a fund include the investments held, expenses incurred, and performance history. Now that we understand how funds incur costs, we can use this information and the assets held to evaluate a fund’s performance history!
Thus expense ratios are one of the most significant considerations you will make second to the index or the active fund manager you choose. Why? Because expense ratios get paid regardless of whether a fund makes or losses money.
Does it matter?
So, as we have discovered, expense ratios matter. They directly influence how funds perform day in and day out, which means they directly affect your money. Now, as is everything in life, expense ratios are not the only decision-making factor when choosing a mutual fund. Instead, they are one of many considerations. So, whether you choose indexed or active, you should always weigh the expense ratio.
Curious what other considerations exist besides the expense ratio? These will be covered in subsequent articles that I have linked and include: What a fund’s turnover ratio is [link], what type of account to hold a fund in [link], and what company you do business with [link].
Remember: No two people have the same situation, so always choose what is best for you based on your preferences, situation, and goals! Remember, these are your hard-earned dollars. I believe that index funds are an investor’s best friend. Still, I also like to gamble, so I always hold a percentage of my portfolio in active funds. Regardless, I monitor the expense ratios of both! What do you think? Do expense ratios matter when you invest? Let me know in the comments below, and as always, have a great day!
Mile High Finance Guy
finance demystified, one mountain at a time