Why You Should Care About Expense Ratios

Think small

While I understand the basics of what expense ratios are – fees, so the lower the better – I have a hard time explaining what they are and their impact on your money. I’m not a financial professional, so this may be over simplifying. And please, someone, correct me if I’m way off.

I’m going to pretend I’m explaining this to someone who doesn’t want to understand investments, but perhaps should (mom!).

The first official definition I see is from Morningstar:

The expense ratio is the annual fee that all funds or ETFs charge their shareholders. It expresses the percentage of assets deducted each fiscal year for fund expenses, including 12b-1 fees, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund.

What?! Am I supposed to know what 12b-1 fees are? The first line says it best: it’s the annual fee charged to shareholder. That’s you, the account holder.

But I don’t see it on my statement. How am I paying this fee? 

Nothing is free. Your investments are managed by people and companies that are in business to make money. Mutual funds and exchange-traded funds (ETFs) bundle their fees into this “expense ratio.” You’re not going to see this as a line item on a statement of your account transactions, but they have an impact on your investment returns.

What are these expense ratio fees for? 

There are different costs with managing different funds and these costs are paid for (at least partly) through the expense ratio fees. These may include paying the fund manager, custodial services, record keeping, legal, marketing, auditing, accounting, etc. Basically, paying the machine that keeps the firm running.

Do I have to pay this? 

Yes, but you have some control in how much you choose to pay.

How much are we talking and how will it impact me? 

Expense ratio fees can range from 0.01% to 2.5%. To any retail shopper, this sounds like small potatoes, but over time, these rates can have a big impact. I searched for a calculator for this example, but found the results varied, so take this just as an example. I used the SEC’s Tool for Comparing Mutual Funds. 

Say you invest $10,000. Assume an average annual gain of a 10% over 20 years:

  • With 0.91% expense ratio = $11,241 in costs; Balance = $56,034
  • With 0.04% expense ratio = $536 in costs; Balance = $66,739

That’s over a $10,000 difference! This is a really simplified example with no additional contributions and without consideration for a host of other factors. But you can control this $10k difference and it only takes a few minutes.

So, what can I do?

Let’s look at your retirement account and see where it’s invested. With Vanguard, I can easily see the expense ratio by fund. Since my IRA is a mash up of multiple 401k roll-overs, my account was invested across over 10 different funds. I have gradually sold them, in order of highest expense ratio, purchasing low cost index funds instead (VTSAX). I’m down to these six (look at that Fidelity at 0.01%!):

I don’t sell them all at once because there’s a $50 fee for making more than one of these transactions within 60 days. And since I’m no good at math, I’m not going to calculate the impact of these waiting periods, I’m just avoiding the $50 hit.

To trade the high expense ratio funds for lower expense ratio funds, I follow the steps from my Vanguard account: 1) buy and sell and 2)  Trade an ETF or stock. I trade “all” of the high expense account. Once that transaction goes through, it will be held in my money market fund until I add it to my VTSAX fund.

I tried to keep this simple, but it’s not a very simple subject for the non-fiscally minded. And I know I don’t know anything – I’m just scratching the surface here.