If you’ve started investing or are learning about investing, you’ve probably heard of the term ‘expense ratio’.
But what exactly is an expense ratio?
How does it work and why does it matter?
Keep reading to find out the answers to these questions.
What Is An Expense Ratio?
According to Investopedia, a fund’s expense ratio (ER) is a measure of the fund’s operating and administration expenses.
The ER is determined by dividing these expenses by the average dollar value of the fund’s assets under management (AUM):
Expense Ratio = Total Costs / Total Assets
As indicated by its definition, the ER of a fund is essentially the cost of investing in that fund.
ERs are applicable to funds like mutual funds/unit trusts or ETFs and are charged by the investment firm.
How Do Expense Ratios Work?
A fund’s ER is usually expressed as a percentage that is charged annually and can be found in the fund’s information.
This means that as the fund’s assets grow, the dollar cost of the ER increases – just as how 0.5% of $100 is only $0.50 but 0.5% of $1000 is $5.
When you invest in an ETF or a unit trust, you never actually see the ER being charged to you.
This is because the ER of a fund is deducted directly from its net asset value (NAV).
That is, when a fund pays for its ER, it is reflected as a decrease in the NAV of the fund rather than an explicit cost to investors like when commission fees are charged.
And since a fund’s NAV is also affected by things like market volatility and economic sentiment, most investors probably wouldn’t notice when a fund’s ER was deducted.
What Affects The Expense Ratio?
Based on the formula, a fund’s ER is affected by anything that affects its costs or AUM.
A lot of factors affecting cost depend on the type of fund in question.
Passive Management vs Active Management
This is a major determinant of the costs incurred by a fund because it is related to the resources the fund utilises.
Passive management is when a fund (usually ETFs) tracks an index.
In these cases, fund managers only need to ensure that the fund’s holdings are identical to that of the index.
No work goes into market analysis or deciding what trades to make, at what price to make them, or at what time.
One example of a passively managed fund is the VOO ETF which tracks the S&P 500 index.
On the other hand, active management is when a fund’s fund managers are actively engaged in doing work in an attempt to maximise returns.
This usually includes many hours being spent on market analysis, risk management, and trying to time the market.
Examples of actively managed funds include the ARKK ETF or unit trusts/mutual funds.
Since actively managed funds inherently involve much more man-hours than passively managed funds, they tend to have higher administration costs.
They are also likely to incur higher operational costs by making more trades as compared to a passively managed fund.
ETF vs Unit Trust/Mutual Fund
This builds off of the previous point because most ETFs are passively managed while most unit trusts and mutual funds are actively managed.
As a result, ETFs generally have lower ERs than unit trusts/mutual funds, though there might be exceptions.
Other than the difference in fund management style, the difference in product structure is another reason for the difference in ER.
ETFs are traded on the stock exchange like stocks, so all trades occur between investors only – there is no interaction between investors and ETF fund managers.
However, investment companies are directly responsible for the buying/selling of mutual funds by investors, which results in more administrative work involved.
This translates into additional costs that are passed on to investors in the form of higher ER.
A fund’s inception date has an impact on its AUM and thus its ER.
In general, funds that have been around longer (ie have an earlier inception date) have a higher AUM and a lower ER.
This is probably because there’s been more time for investors to buy these funds to increase the AUM.
Also, the underlying investments of the fund would have had more time to increase in value and increase the fund’s AUM organically.
How Do Expense Ratios Impact Investments?
Even though we never explicitly see a fund’s ER being deducted from our portfolio, at the end of the day, it is still a cost to us as investors if we invest in ETFs or unit trusts.
This means it has a direct impact on our portfolio’s performance.
Even though ERs may be reasonably low, due to the effect of compounding over many years, even low ERs can snowball into large dollar costs.
So, as with all costs, it’s in our best interest to minimise the ER of our portfolio as much as possible in order to maximise returns from our investments.
How To Minimise Expense Ratios
Same Index, Different ETF
To minimise expense ratios, the first thing we should do is to look for funds that have the lowest expense ratios when investing.
When it comes to ETFs and unit trusts, there is usually a multitude of options that invest in the same thing.
For example, there are numerous S&P 500 ETFs from different investment firms that all track the same S&P 500 index.
Even though they do the same thing, these ETFs have different ERs, so choosing the one with a lower ER is usually beneficial, though there may be other things worth considering like withholding tax.
Similar Index, Different ETF
Another thing we can do is to consider similar options that may not be entirely identical to each other.
For example, there are many different world ETFs that track different world indices.
While there are slight differences between them, they tend to remain very much similar at a macro level.
The cost of these differences can be as much as 0.16% in ER, though it seems like a deceivingly small difference.
Finally, instead of investing in a highly diversified ETF with a higher ER than a less diversified alternative which has a lower ER, it might be a better idea to replicate the highly diversified ETF with multiple ETFs.
For example, say you want to invest in a world ETF and are considering 2 options – SWRD and VWRA.
The main differences between the 2 ETFs are:
- SWRD has an ER of 0.12%, VWRA has an ER of 0.22%
- SWRD tracks the performance of large- and mid-cap stocks from developed markets, VWRA tracks the performance of large- and mid-cap stocks from developed and emerging markets
So while SWRD has a lower ER, it is less diversified than VWRA since it doesn’t cover emerging markets.
But even though VWRA is more diversified than SWRD, it’s not too much more diversified – stocks from emerging markets only make up ~10% of its portfolio.
So if you want to recreate the holdings of VWRA, you could consider a 9:1 split of SWRD and EIMI (emerging markets ETF).
Given that the ERs of SWRD and EIMI are 0.12% and 0.18% respectively, the total ER for a 9:1 portfolio of SWRD and EIMI would only be 0.126%.
This way, you get a similar portfolio to VWRA but at a much lower ER.
However, you may incur higher transaction costs since you’d have to buy 2 ETFs instead of just 1, and it may require more work to manage a 2-fund portfolio.
Not The Be-All End-All
While minimising the ER of our portfolio should be a priority, it’s definitely not the be-all and end-all.
ERs are but 1 of many factors when it comes to investing and there are other things that are equally as important to consider.
There are times when it may make sense to choose funds with a higher ER, such as when you expect it to generate outsized returns as compared to an alternative with a lower ER, for example.
You might also consider the country of domicile of a fund since it affects the dividend withholding taxes that are applicable, which is yet another cost of investing.
Or perhaps convenience and ease of managing your investments are more important to you and you don’t mind investing in funds with higher ERs.
Ultimately, understanding expense ratios and knowing how to minimise them can help you make more informed decisions about investing