Financial Literacy Friday: Expense Ratios
Welcome back to another edition of Financial Literacy Friday where today I wanted to talk about expense ratios and how they can affect your investment experience. Broadly, expense ratios are the administrative fees that cover the cost of running a mutual fund and almost all mutual funds have them at various price points. While they are important as you don’t want to drown in fees, they are not the be all and end all of choosing which mutual funds in which to invest. Let’s take a closer look at what they actually are first.
How Do Expense Ratios Work?
As I mentioned, expense ratios are the internal fees associated with running a mutual fund. These include custodial fees, administrative fees, fund manager fees, taxes, accounting, and recordkeeping fees. While the largest portion of this fee goes to the fund manager or advisor, all of these are combined into one number. The expense ratio is calculated by dividing that particular fund’s operating expenses by the assets in that fund and will reduce the return to investors. This means that if you are invested in a mutual fund and it returns 6% and the expense ratio is .3% then your total return for being invested with that fund is 5.7%. Obviously expense ratios can run the gamut from the new Fidelity funds with 0 expense ratios to expense ratios that are quite high at several percentage points. However, by simply looking at expense ratios, you would get the idea that they have an inflated importance to the success of your investments, so let’s talk about the role they play.
The Importance of Expense Ratios
Obviously everyone wants the best returns they can get and by reducing the expense ratio you can get slightly higher returns, so that seems like an easy way to get what you want. However, that may not always be the best option as I’m sure everyone has faced a situation where it was worth paying a bit more to have a better experience. The way I like to think about expense ratios is by comparing them to buying airline tickets. We’ve all had the experience of searching for flights and looking for the best deals and wanting the cheapest flight. However, by buying a flight on a discount airline you quickly realize that while you underpaid for the actual ticket you will have to pay to choose your seat, take a bag, get a drink, get a snack, and a whole host of other extras that are normally complimentary. However, if you buy a flight on a more established airline like Virgin or Alaska the flight will be a bit more expensive but you’ll get a free checked bag, you’ll be able to choose your seat, you’ll get a snack and likely a glass of wine on the flight. Low expense ratios are great, but you need to be aware that there are funds companies who will be tacking on additional charges to make up for the low initial price point. In many but not all cases, you get what you pay for. Paying a bit more of an expense ratio to have a smooth investment experience may be more worthwhile than going the discount route.
What are your thoughts on the fees you pay to invest? What kind of person are you, someone who doesn’t mind paying the added on fees or someone who simply wants to avoid that hassle? I’d love to hear how you view this aspect of investing, so send me an email if you’re willing to discuss your thoughts.