What are the key metrics you look at when you are assessing a fund? Over the next few weeks, I will talk about my 5 and explain them in some detail. Stick around, this week I am talking about the cost of funds.
An expense ratio (aka Total Expense Ratio, or Net Expense Ratio) is a fee charged annually to cover the operating and admin expenses of ETFs and Mutual Funds. The cost is deducted from the amount you invest and thus diminishes your returns each year. It is taken regardless of the performance of the fund (so if your investment is flat for the year, you will make a loss once these fees are deducted).
High expense ratios can drastically reduce your returns over the long term which makes it imperative for long term investors (which you all know I am) to pay close attention to expense ratios, when picking your Mutual Funds and ETFs. You want those ratios (which are unavoidable) reasonable or low.
I like to describe it as the “convenience fee” we pay for not having to worry about picking and trade individual stocks. For mutual funds that are actively managed, the fund manager is compensated from this fee. For tasks like overseeing the portfolio, and taking actions like Rebalancing (I will explain this term in detail in the future). As you can imagine the more popular “rockstar” fund managers mean those funds will have higher expense ratios.
But technology always shows up to help reduce those fees. For ETFs and Mutual funds that are passively managed (do not have active investment selection but aim to duplicate the performance of an index like the S$P500, Nasdaq or the FTSE) expense ratios for these are usually cheaper and the net returns over time are better than most fund managers (in my opinion and that of a lot of people) you can read more about it here.
So what is a good expense ratio? Good question, first you need to consider if it is actively or passively managed. Cathie Woods is one of the rockstar managers right now and her ratios are around 0.75% (meaning you pay $7.5 for every $1k invested). The average expense ratio is probably around 0.66% ($6.6 per $1k invested) for actively managed funds like ARKG and co. (Which makes Cathie over the average) and for passively managed funds like VOO and QQQ the average expense ratio is a low 0.13%, that is $1.30 per $1k super cheap. So as long as I am not too far from the average, I am happy.
But Chibby, Why does a $1 in fees difference matter? You all know I am all about the bigger picture and the long term. So let’s do a worked example to show you the difference.
Imagine 2 funds, both tracking the S&P500 but with different expense ratios.1k invested and you do not touch it for 30 years (when you child is ready for marriage or you are ready to retire).