The average expense ratio of index funds, ETFs, and mutual funds can vary depending on the specific fund, its asset class, the fund provider, and other factors. In this article, we’ll learn what an expense ratio is, how it’s calculated, the average expense ratio, and how it affects your portfolio.
What is an expense ratio?
Index funds, ETFs, and mutual funds charge fees in the form of an expense ratio.
The expense ratio represents the annual cost of owning the fund and is expressed as a percentage of the fund’s total assets.
The expense ratio covers various operating expenses, including fund management fees, administrative costs, custodial fees, and other expenses associated with managing the fund. It is calculated by dividing the total expenses of the fund by its average net assets.
The expense ratio is not a fee that investors pay directly out of pocket. Instead, the fee is deducted from the fund’s assets, and the resulting net asset value (NAV) reflects the cost of owning one share of the index fund.
For example, if an index fund has an expense ratio of 0.25% and its net asset value is $200 per share, the annual cost of owning that index fund would be $0.50 for every $200 invested. The net return the investor receives is based on the total return the fund actually earned minus the stated expense ratio.
Passive vs active investing
Another thing you need to understand is the difference between passive and active investing.
In an actively managed fund, a human investment manager actively buys and sells assets in the fund to try and beat the market. In a passively managed fund, investors simply invest into an index (an existing group of assets) with the goal of matching the market performance.
Mutual funds are actively invested funds and has much higher fees than index funds and ETFs, which are both passively invested funds.
With a mutual fund, the performance of the fund relies on the human investment manager to make smart decisions. With ETFs and index funds, the performance of the fund depends on the collective performance of the individual assets within the fund.
Average expense ratios of mutual funds, index funds, and ETFs
Mutual funds: average expense ratio
As mentioned above, mutual funds have the highest expense ratios because they’re actively managed funds. The average expense ratio for actively managed mutual funds can range from around 0.50% to 2% or higher, depending on the fund’s investment strategy and management style. Some actively managed mutual funds, particularly those with specialized strategies, can have even higher expense ratios.
Here’s how the expense ratio fees from a mutual fund might be broken down (not all funds have all of these fees).
- Management fees to compensate the investment manager managing the account’s portfolio. They do all the research, follow the market, and make all the buying and selling decisions in order to try and beat the market.
- 12b-1 fees: Marketing costs and sometimes even employee bonuses are passed onto the investors of the fund. This portion cannot exceed 1% of the investor’s assets.
- “Other expenses”
- Account fees that can be applied to accounts that fall below a certain threshold.
ETFs and index funds: average expense rate
Let’s group ETFs and index funds together since they both share similar expense ratios.
The average expense ratio for ETFs and index funds is around 0.1%. However, expense ratios of ETFs and index funds can vary greatly. You might find some with an expense ratio of 0.15% while ultra-low funds could have expense ratios as low as 0.05%.Some index funds or ETFs may have higher expense ratios if they track niche or specialized indices, while some actively managed mutual funds may have lower fees if they are from certain fund providers or offer institutional shares.
The impact of expense ratios
Remember than expense ratios are charged as a percentage of your position in that fund and is charged annually. That means, that the higher the value of your assets, the higher the fees you’ll pay each year. For example, a 1% expense ratio for a mutual fund on a $1,000 might seem small at just $100. But with a $5 million dollar portfolio, you’ll end up having to pay $50,000. That money comes out of your portfolio, reducing the amount that can be compounded over the long run.
Compare that with an expense ratio of 0.05% for an index fund or ETF. Suddenly, the same $5 million dollar portfolio only pays $2,500 rather than $50,000. Not only do you save $42,500 in fees, it also gets to be compounded in your account giving you bigger returns for the next several years.
How to avoid high expense ratios
Mutual funds have the highest expense ratios, oftentimes being over 10x greater than the expense ratios for ETFs and index funds. Unless you’re confident that you want to actively invest your money through a mutual fund to try and beat the market, you may be better off just looking for ETFs and index funds with low expense ratios. Also keep in mind that you’ll have to pay the higher expense ratio regardless of whether the mutual fund makes money money or not.
Fortunately, funds based on major indexes (such as the S&P 500) have very low expense ratios. So if you’re just trying to match the market through major indexes, ETFs and indexes provide a cost-effective option. d