Ask Your Financial Advisor How Expense Ratios Work
When you invest your money in a particular instrument, you put in your funds, and that money grows in value with rewards and profits. If things do not work in your favor, you could also suffer from losses. However, this is not the only outflow of money in an investment. Every investment comes with some costs, such as administration fees, commission fees, fund manager fees, or expense ratios. These costs are associated with different types of products and can differ based on the type of instrument you pick and the money you invest. Expenses ratios, in particular, are one of the most commonly known costs that you are likely to come across in investment documents. This article talks about what these are and why it is important to know about them.
Here are some questions to ask your financial advisor to know how expenses ratios work.
- What is an expense ratio?
- Does an expense ratio differ for actively managed funds and passively managed funds?
- How is an expense ratio charged?
- How is an expense ratio calculated?
- How to determine if the expense ratio being charged to you is good or not?
- What are the factors that determine the expense ratio for an investment?
- How can you find out the expense ratio before investing?
An expense ratio is an annual fee that you pay as an investor when you invest your money in tools like mutual funds, exchange traded funds (ETFs), etc. This fee is charged to cover operational expenses, fund management fees, administrative fees, marketing costs, and the commission of the agent, among other things. The expense ratio is not shown to you for each day of the investment, but is charged on an annual basis at the end of each year. When you earn a profit on your investment, the expense ratio is deducted from the overall profit, and the remaining funds are given to you as returns from your invested money. Hence, a high expense ratio can affect the earnings from your investments.
Although the basic principle of how expense ratios work remains the same for both actively managed funds and passively managed funds, the things that you are charged for are different for both these approaches. As you may know, passive investing refers to investing in a mutual fund or ETF with the aim to mimic the performance of the benchmark. As opposed to passive investing, active investing involves a more rigorous approach of proactively timing the market, picking the right opportunities, etc. Hence, the expense ratio of a passive investment instrument is usually lower since there is little work that goes into it. The primary costs involved here are the licensing fees that are paid to the index for tracking the benchmark. Active investing, on the other hand, may have a higher expense ratio since the fund manager does multiple tasks at once. This involves rebalancing the portfolio, making changes as needed, to stay on track with the primary goal of investing, etc. The expense ratio can be a significant factor while choosing between active and passive investing. So, before selecting a particular investment tool, it helps to ask your financial advisor about the expense ratios involved in your choice.
You do not pay expense ratios in a separate transaction. So, you do not have to cut a check to your fund manager for the costs incurred. Instead, an expense ratio is charged directly to you annually. The total expense ratio is simply deducted from your returns. The net asset value (NAV) of the fund you invest in is inclusive of the total expense ratio charged to you.
It is easy to calculate the expense ratio for a particular investment. The formula used is as follows:
Total expense ratio = Total fund expenses / Total assets under management You can ask your financial advisor how this works for the funds you invest in.
This is a major cause of concern for most investors. The expense ratio determines your total profits for a fund. The higher the expense ratio, the lower would be your returns. Hence, it is important to know how much is adequate and how much is too much. In order to know if you are being overcharged or not, you first need to know the type of your investment instrument. As stated before, the expense ratio differs for actively managed and passively managed funds. For actively managed funds, an expense ratio ranging between 0.40% to 0.75% is generally considered reasonable. The expense ratio for an international fund may be higher than this and approximately touch 1%. An expense ratio higher than 1.5% may be a high charge. Passively managed funds would typically come with an expense ratio of 0.2%. The figure could also be lower than this.
The expense ratio is calculated as per various factors. The type of investment (active and passive), size of the investment, etc., are primary aspects that are looked at. Domestic funds are generally more cost effective than international funds since the overall expenses involved in managing them are a lot lower. Similarly, small cap funds have a higher expense ratio than large cap funds due to the limitations of their size.
You can ask your financial advisor to research and find out about expense ratios of different funds. This is perhaps one of the most important questions to ask your financial advisor as it will ascertain the future outcome of your investment. In addition to this, you can do some research on your own too. There are several online tools that allow you to calculate the percentage of cost to be incurred. You can also consult the SEC Mutual Fund Cost Calculator, an online tool offered by the U.S. Securities and Exchange Commission.
To sum it up
Although the expense ratio should not be the only criteria to determine your choice when it comes to investing, it does play a crucial role in the process. High expense ratios can eat into your profits and nullify the reason to invest in the first place. But it is important to consider other aspects, such as the type of investment, the overall returns, etc. before making the final decision. Asking your financial advisor these seven questions will help you understand how to calculate the expense ratio and how it can impact your gross earnings.
If you have any more questions on expense ratios and how they impact your investment returns, you can reach out to a professional financial advisor in your vicinity and pick a suitable fund thereafter.