Fund expense ratios explained

The expense ratio is a fee that occurs in all mutual and index funds.  In fact, it is even nested inside of exchange traded funds, though in this case the fee is generally lower than it’s index fund or mutual fund counter part.  The options that present themselves in your 401k, IRA, TSP, or non-retirement index fund and mutual fund accounts will have fees that the honest brokers will explain and less than honest brokers will try to obfuscate.

The expense ratio is this:

The annual fee expressed as a percentage of the assets under management charged directly against those very assets.  The expense ratio is paid internally to the account, so many do not realize that this fee exists at all.  However, this fee, if substatial can become a redistributor of wealth from the account to the managing institution.  It is money that is forfeited in exchange for management and operating expenses, reagardless of profits or even losses.

Take a $10,000 portfolio for example.  The value of which did not change through out 2012.  A 1% expense ratio means that $100 is paid out of this fund to the manager/broker, leaving a balance of $9,900.  If the value went up 10% in 2012 instead, the manager would still recieve 1%, or $110, leaving $10,890.  This will effect compound interest and the Time Value of Money over time.  What was a 10% return is now a 9% return.  This will carry on for as long as you are invested in this fund.  It is in your best interest to minimize this fee.  Below are some expectations for what this fee should be.  If your investments fall within this range, there is no real concern.  Even if you can find a lower rate, there may be other benefits with your current institution, such as multiple account discounts, loyalty programs, or the convenience of one stop shop banking.

  • Expect to pay more for an “actively managed” fund.  Fees here range from 0.5% to 1.5%.  They’re not necessarily better.  Remember the manager is not really accountable for your losses and can always explain them away by blaming the market.  Good active fund managers are exceedingly rare to find, and as their funds grow in size, they tend to under perform the overall market, as it is more difficult to move larger amounts of money without being noticed.
  • The index fund is your friend.  The cheaper, the better.  These funds track a computer generated index portfolio of stocks based on a pre established rule set.  All personal bias and emotion driven mistakes are removed here.  The S&P 500 is an example index.  Index fund expense ratios should be below 0.5% and can reach close to no cost.  The Thrift Savings Plan available to federal employees and military service members offers some of the lowest rates possible at 0.025%.  That’s right, $2.5o for each $10,000 invested.  Now that’s a good deal!
  • Fund houses that specialize in funds, particularly actively managed funds, may have front-end and back-end load fees.  These are fees to buy into and then sell out of the fund.  In the past, these fees could be up to 5% on either side.  This fee in general has been done away with as consumer champion Vanguard has driven this fee out of the fund industry.
  • In addition, certain funds have fees if sold within a certain period, commonly 2 to 12 months.  If you plan on being long term in these funds, this is not necessarily a bad deal.  The reason for these fees is to reduce turnover; which is the rate of buying and then selling assets within the fund.  The action of turnover has negative tax consequences and reduces that ability of a fund to achieve target performance.  Early termination fees should be 2% or less.

For reading additional information of stocks, bonds, index funds, and other investment opportunities, please visit the FPO investment page.


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