What Is an Expense Ratio? Here’s How To Find a Good One.

Investing in various types of funds (mutual funds, index funds, ETFs, etc.) can be an excellent way of diversifying your portfolio. That’s because funds, by their very nature, consist of multiple assets, so when you invest in a fund, you’re taking a stake in all the assets that underlie that fund.  

But it’s important to note that investing in funds isn’t free. All funds charge fees, and before you agree to invest in any fund, you should have a sense of what these fees are. A fund’s expense ratio will help you do exactly that. 

Below, we take a closer look at what an expense ratio is, what it includes, how it’s calculated and why it matters.  

What is an expense ratio? 

An expense ratio is a metric that tells investors how expensive it is to invest in a given fund. It’s communicated as a percentage of assets under management (AUM). The lower the expense ratio, the less expensive a fund is considered to be; the higher the expense ratio, the more expensive.  

Investors use a fund’s expense ratio to understand how much money they will pay in fees each year for the privilege of investing in a fund.  

Imagine, for example, that a fund carries an expense ratio of 0.25. That means that for every dollar you invest into the fund, you will pay 0.25 percent in fees each year. In other words, for every $10,000 you invest in the fund, you’ll be on the hook for $25 worth of fees. 

What is included in an expense ratio? 

The costs that make up an expense ratio are typically broken out into two main buckets: management fees and operational expenses.  

Management fees are charges that compensate the fund manager for their expertise and time as they craft the fund’s investment strategy and select assets to buy and sell.  

Operational expenses, on the other hand, refer to other expenses to operate the fund that include (but aren’t limited to): 

1. Legal  

2. Record keeping  

3. Accounting  

4. Taxes  

5. Marketing and advertising  

6. Distribution  

7. Administration  

8. General overhead 

What is not included in an expense ratio? 

It’s important to note that some additional costs, such as those related to the fund’s buying and selling of assets, are not factored into a fund’s expense ratio. This includes redemption fees, contingent deferred sales charges (CDSCs) and loads.  

Are expense ratios charged every year? 

Yes, expense ratios are paid annually. If you own a fund for less than a year, the asset management company may prorate the charges when you sell the fund.  

What is the expense ratio formula?  

A fund’s expense ratio is calculated by dividing total fund fees (including operating expenses and management fees) by the fund’s total assets under management. 

Once you know a fund’s expense ratio, you can use it to estimate how much you will pay in fees each year you are invested in a fund. To do so, all you need to do is multiply your investment amount by the expense ratio (as a decimal).  

Why is expense ratio important?  

How much a fund charges in fees can significantly impact your portfolio’s performance over the long term. A lower expense ratio means lower fees and more money in your portfolio each year that can grow and compound; a higher expense ratio means higher fees eating into investment or earnings. 

How does expense ratio affect returns? 

To show how much of a difference a fund’s expense ratio can make, let’s look at an example of three investors. Each starts by investing $100,000 in identical funds. Each leaves the money invested for 20 years and earns an average return of 6 percent. The only difference is the expense ratio that each investor is charged. 

After 20 years, despite investing in the exact same underlying assets and earning the exact same return, Investor C walks away with more than $36,000 less than Investor A—all because of a higher expense ratio.  
 
While 0.40 percent or 0.60 percent may not seem like much, over 20 years of compounding, this rate can take a serious bite out of your investment returns. That’s why it’s so important to understand a fund’s expense ratio when selecting investments.  

What’s a good expense ratio? 

Generally, expense ratios range from 0.01 percent to 1 percent (though there are some funds that have an expense ratio higher than 1 percent), depending on the fund type and what it requires to maintain. What’s considered a “good” expense ratio will vary depending on whether a fund is actively managed or passively managed.  

Actively managed funds get a lot more attention from a fund manager, which translates into higher management fees. Passively managed funds, on the other hand, are typically pegged to an index, and receive much less hands-on attention from the fund manager.  

Mutual funds often carry higher expense ratios than ETFs or index funds, because many mutual funds are actively managed, while most index funds and ETFs are passively managed (though there are, of course, exceptions). Consider the fact that in 2022, the average equity mutual fund carried an expense ratio of 0.44 percent, while the average equity ETF carried an expense ratio of 0.11 percent. 

Is high expense ratio good or bad? 

Generally speaking, the lower the expense ratio for a similar investment, the better. If you’re presented with the option of investing in two identical funds where the only difference is that one carries a lower expense ratio, that’s probably the better choice. That said, higher expense ratios—particularly for actively managed funds that help you achieve a certain goal—may be okay. 

Weighing expense ratio with other important metrics 

A fund’s expense ratio is an important consideration when evaluating whether to include it in your portfolio. But it isn’t the only metric to consider. Other metrics you should evaluate when considering a fund are: 

1. Load: Mutual funds commonly charge load fees, which can be thought of as a commission paid to the company. Front-end loads are charged when you buy shares of the mutual fund, and back-end loads are charged when you sell shares. No-load mutual funds also exist. 

2. 12b-1 fees: This is an annual marketing fee charged by mutual funds. As an operational expense, it is included in a fund’s expense ratio. However, it is broken out as a line item so that investors can have a better understanding of how the mutual fund company is using money to market the fund. The name comes from the SEC rule that authorizes them. 

3. Turnover ratio: A fund’s turnover ratio tells you how much the fund’s underlying assets have changed in a given year. If a fund has a 10 percent turnover rate, that means that 10 percent of its assets were replaced in the preceding year. Actively managed funds tend to have a higher turnover rate than passively managed funds. Funds with a higher turnover rate often result in higher taxes—which cut into your earnings.  

A financial advisor can help you evaluate your options 

To build and manage your own investment portfolio, you’ll need to consider a lot of different factors: your investing goals, risk tolerance, investment horizon and yes, fees. Choosing funds with an expense ratio that is too high, even if they check all of your other boxes, may mean you’re leaving money on the table—money that you could be putting toward other financial goals.  

Financial advisors are trained to consider all of these factors when designing a portfolio that will best help you meet your goals. A Northwestern Mutual financial advisor can also help you think about how investment decisions work with other parts of your financial plan—such as life insurance, disability insurance, estate planning—to reach your financial goals. 

All investments carry some level of risk including the potential loss of all money invested. No investment strategy can guarantee a profit or protect against loss.