What’s an Expense Ratio?

Well, isn’t this your lucky day!

We get to talk about how to triple your money in less than a month with a no-risk secret strategy. What’s that? It doesn’t exist? So, now what? Well, it looks like I won’t be sharing that secret, but I have something just as exciting. I’m going to talk to you more about fees!

This next one is actually common and important. You’ll want to know about it.

The first is an expense ratio.

When you invest in an individual stock or bond, you pay the transaction fee or maybe a commission, but then that’s it. There is no ongoing “management.” You own the stock and that’s that. But, when you buy a mutual fund or ETF, for example, the idea is that you are buying a basket of investments and that this basket of investments takes expertise to manage throughout the year. You have people, investment managers, who are buying and selling investments within the mutual fund or ETF. This is especially true for active managers, but even with a passive index fund, there are still some trades that occur and some expenses. That website where you can log in and see your portfolio or the statement that comes each month will cost you money.

Okay, so back to expense ratios. This is the fee you pay these managers. It is a flat percentage that represents an annual fee. For example, if the expense ratio is 1% and you have $100,000 invested, the annual fee would be $1,000. If you had $1 million invested, the annual fee would be $10,000.

As you can imagine, expense ratios vary widely.

Some funds charge 2% or more per year, while others charge as little as 0.05%. That’s a huge difference. Active managers almost always have a higher expense ratio than passive index managers. Sometimes, it depends on what the manager invests in. Think about this: if you were investing in large U.S. companies, there is a lot of information about companies such as Google, Coca Cola, Wal-Mart, and others. But if your mutual fund invests in small technology companies in sub-Saharan Africa, it might cost you a lot more to do research on these companies and to have analysts on the ground talking to the owners. There may even be currency exchange rate fees and government fees. It could very well cost the fund more in fees just to invest in these kinds of companies.

So, unless you plan on only investing in individual stocks and bonds, you will probably pay fees in the form of expense ratios on your funds. How much you pay depends on many factors, but the biggest factor is your decision to invest in active or passive index funds.

Do you have a sense of an expense ratio?

You can easily find the expense ratio of any mutual fund or ETF online. In fact, that’s your homework. Go to Yahoo! Finance and type in the mutual fund symbol for VFIAX. It’s the Vanguard S&P 500 Index Fund. Then click on “Profile” and you’ll see a section titled “Fees & Expenses.” Check it out.

What else can you check out? Me in the next lesson. I’m going to discuss AUM. What’s AUM? You’ll get your Ph.D. in AUM ASAP.

The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.