Expense ratios are one of many fees investors may encounter, but they are among the most important because they directly affect investment returns. An expense ratio represents the operating costs of a mutual fund or exchange traded fund relative to its assets and is automatically deducted from the fund’s gross return. Investors never need to calculate it themselves since it is listed in the fund’s prospectus, on financial websites, and often directly within retirement account platforms. Expense ratios are often expressed in basis points, where one basis point equals one hundredth of a percent. For example, a 0.12% expense ratio equals 12 basis points, meaning an investor with $100,000 in that fund would pay $120 per year.
Low expense ratios are critical because high fees can significantly erode investment returns over time. While a 12 basis point fee is considered very low, many funds still charge 1% or more, which equals 100 basis points annually. In some cases, funds may charge even higher fees, such as 2.4%, which would cost $2,400 per year on a $100,000 investment. If the fund returned 5% in a year, that 2.4% expense ratio would consume nearly half of the investor’s gains. This demonstrates why keeping costs low should be a priority for any thoughtful investor.
Fortunately, expense ratios have declined significantly since the rise of index investing led by John Bogle. Today, many diversified, tax efficient, low cost funds are available through firms like Vanguard, Fidelity, and Schwab, with some funds even offering zero expense ratios. However, investors should avoid obsessing over tiny differences such as seven versus nine basis points. The real objective is to move from high cost funds to low cost ones, not to chase minimal improvements once fees are already very low. Every investor should know the expense ratios of their investments and understand what they are paying.
Hello. My name is Tyler Scott with White Coat Planning. And today, Jim has asked me to come share the principle of expense ratios with you and make sure we have a good understanding of that term.
Both individual investments and the accounts that hold those investments can have all kinds of fees to be aware of. There are sales loads, broker commissions, advisory fees, account fees, management fees, redemption fees, transaction fees, 12b1 fees. It's a cavalcade of fees out there. Today we're just going to talk about one of those types of fees, the one I think you've probably read about and heard about the most when you read on White Coat Investor, and that relates to investment choices, and that is where we arrive at the term expense ratio.
The expense ratio is a measure of a mutual fund, or exchange traded funds, operating costs relative to its assets. It's determined by dividing a fund's operating expenses into its net assets. Operating expenses reduce the fund's assets, thereby reducing the return to investors, because the expense ratio is deducted from the fund's gross return and paid to the fund manager.
You never have to calculate the expense ratio. It will always be provided in the fund's prospectus. You can also just Google it if you know the ticker symbol for the fund in question. It's available on analytics sites like Morningstar or Yahoo Finance. Good and ethical 401k custodians will just provide the expense ratio right on the statement or website where you're looking at the investment options.
In financial conversations, you'll sometimes hear expense ratios expressed as basis points, or bips for short, written out bps. When I say basis point, that is referring to 1/100 of a percentage point. It is the cost of the investment expressed as a percentage. If you have an investment that has an expense ratio of 0.12%, that's the same as saying the fund has an annual fee of 12 basis points. That means you owe 0.12% of the value of that investment each year to the firm that created the investment like Vanguard or Fidelity. So if your investment is worth $100,000, you owe them 120 bucks for the year.
Twelve basis points is a very low cost fund. Sadly, most mutual funds and exchange traded funds out there are not low cost funds. It's not uncommon for me to review a client's list of available funds in their 401k, 403b, or 457, and see that all of the options have expense ratios of 1% or higher. In other words, the fees are 100 basis points and up.
When I was working at a public health dental clinic in Oregon, we had funds in our 457b with 240 basis point fees. That is a ridiculous 2.4% expense ratio. If I had $100,000 in that fund, they would charge me $2,400 each year, every year, just to own the fund. Now imagine my investment returns for the year in that fund were 5%. That means the expense ratio would consume a whopping 50% of my investment return for the year. I'd have to give away half of my growth to the underlying investment. Thus, keeping expense ratios in your investments low should be a goal for any savvy investor.
Fortunately, there has been a lot of pressure to lower expense ratios since John Bogle started the index fund revolution at Vanguard in the mid 70s. Today, there are many wonderful, tax efficient, highly diversified, low cost funds available at places like Vanguard, Fidelity, and Schwab. Fidelity even offers their so called Zero funds that have an expense ratio of zero.
Funds like this can be compelling to people once they learn about expense ratios, but some folks can become a little obsessive about whether a fund costs seven bips or nine bips. Don't worry about that. Don't be that person. Jim often talks about anything below 20 basis points doesn't really matter. The goal is not to go from nine basis points to seven. The goal is to go from 145 basis points to nine.
If you don't know the expense ratio on the funds you're using, go find out. A good investor always knows what they're paying for their investments.
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