Investing in mutual funds and exchange trade funds is simultaneously easier and more complex than you would believe. That's because with investing comes a slew of new financial jargon that most investors overlook. When selecting a fund, one often overlooked feature is the expense ratio.
But what is an expense ratio and how does it affect you as an investor? While an expense ratio isn't the only thing you should consider when selecting a fund, it's something that can dramatically affect your investment returns.
What is an expense ratio?
An expense ratio measures the operating and administrative costs of a mutual fund or an exchange trade fund. All funds have some administrative costs which include record keeping, accounting, auditing, and more. However, the biggest portion of the expense ratio typically goes to the fund management team.
What does the expense ratio tell me?
First and foremost, the expense ratio tells you how much your investment return is reduced by administrative costs. A lower expense ratio is typically characterized by a higher return on your invested capital.
An expense ratio will also tell you whether or not a fund is actively managed or passively managed. Passively managed funds will always have lower expense ratios than actively managed funds. If you remember from a previous article here on Christian Money Solutions, passively managed funds are often known as index funds. In other words, they only seek to replicate a particular index rather than trying to beat the market.
Conversely, an actively managed fund attempts to beat a particular index. For example, a large-cap actively managed fund will have a team of analysts who are constantly researching larger US companies. When they find companies they perceive to be undervalued, they will buy with the expectation they will increase greatly in value in the near future. As such, there is a lot more buying and selling within an actively managed fund, which makes them more expensive.
Can you give me an example?
Let's look at two funds, Fund A and Fund B. Fund A has an expense ratio of 0.05%. This tells us a couple of things. For one, it's likely an index fund. For another, we now know that for every $10,000 we invest, we will pay $5 in management fees.
Fund B has an expense ratio of 0.75%. Again, this tells us that it is likely an actively managed fund and that we pay $75 for every $10,000 we invest. While that doesn't sound like a lot, it can add up over the course of 30 years, or once you have hundreds of thousands of dollars invested.
What's a good expense ratio?
Fortunately, expense ratios are far lower than they have been historically. According to the Investment Company Institute, the average expense ratios for index funds and actively managed funds in 2022 were 0.06% and 0.68%, respectively.
When it comes to index funds, aim for the lowest cost possible. For example, let's say you have two S&P 500 index funds. One has an expense ratio of 0.01% and the other is 0.05%. I would go with the 0.01% every time because the extra expense isn't justified in an index fund.
For actively managed funds, you don't really want to go above 1% for large company funds or 1.25% for small company funds, according to Investopedia. There are funds out there that have astronomically large expense ratios, but this is often far too expensive and unjustified.
Should I only invest in index funds since they're cheaper?
While investing in index funds is generally a good strategy, there are also more factors to consider. If you choose to invest only in index funds you will most likely be fine. But it's also important to consider your goals and your values.
To give an example, you may have a problem with investing in companies that also sell alcohol, gambling, or abortion services. As such, you may choose to use a mutual fund that filters out such companies, which will result in a higher expense ratio.
You may also be interested in high-dividend-producing funds, which would result in more income coming to you. These funds also typically have higher expense ratios but may be worth it in the right situations.
Carefully evaluate all funds.
It's important to evaluate any investment. We live in a time and age where there is more transparency than ever when it comes to investments. As stewards of God's resources, we need to be wise when it comes to choosing our investments.
If you need help or further education, I recommend contacting a Kingdom Advisor. These are men and women who are all about eternal perspective when it comes to finances.