Saxo Group
Every investment decision impacts your financial future, but not all costs are obvious at first glance. Expense ratios, which may look like a small percentage, directly influence the returns you earn from mutual funds and exchange-traded funds (ETFs).
Knowing how expense ratios work helps you compare funds effectively based on cost and value. Over time, even minor differences in these fees can compound and significantly affect your portfolio's performance.
An expense ratio represents the annual fee a mutual fund or ETF charges investors to cover operating costs. It is expressed as a percentage of the fund's average net assets. This seemingly small percentage can significantly impact your returns over time, making it essential to understand what it includes and how it is calculated.
The expense ratio encompasses various costs required to manage and operate the fund, including:
Expense ratios are automatically deducted from a fund's net asset value (NAV), covering operational costs without requiring separate charges.
These deductions are built into the daily NAV calculation, so the costs remain invisible to investors but directly reduce returns over time. While seamless, this ongoing fee has a significant long-term impact on portfolio performance.
Funds may report two types of expense ratios:
For example, a fund with a gross expense ratio of 1% but offering a fee waiver of 0.2% would report a net expense ratio of 0.8%.
The expense ratio is determined using the following formula:
Expense ratio (%) = (Total operating expenses ÷ Total fund assets) × 100
For example, if a fund's operating expenses amount to USD 50,000 and the total assets in the fund are USD 10,000,000, the expense ratio would be:
(USD 50,000 ÷ USD 10,000,000) × 100 = 0.5%
This 0.5% indicates you'll pay USD 50 annually for every USD 10,000 invested in the fund.
Example:
Let's say you invest USD 20,000 in an ETF with a 0.3% expense ratio. Over the course of a year, you would pay:
USD 20,000 × 0.003 = USD 60
This fee is deducted directly from the fund's assets, reducing your overall returns.
It's vital to understand the expense to assess a fund's cost-effectiveness and compare it to other investment options. Even slight differences in these fees can add up significantly over time.
Expense ratios vary based on the type of fund, reflecting differences in management approach, investment strategies, and operational requirements.
Actively managed mutual funds typically have higher expense ratios. These costs arise from professional managers who analyse data, research opportunities, and adjust portfolios to outperform market benchmarks.
As a result, expense ratios for mutual funds often range between 0.5% and 1.5%, with some exceeding this range.
ETFs generally have lower expense ratios, with most adopting a passive management approach. Designed to track an index such as the S&P 500 or MSCI Emerging Markets Index, ETFs incur fewer management costs. Expense ratios for ETFs commonly fall between 0.03% and 0.2%.
For example, a broad-market ETF charging 0.03% provides a cost-effective way to gain exposure to specific markets or sectors.
Funds focused on specific sectors or themes, such as technology, renewable energy, or emerging markets, often have higher expense ratios. The added complexity of managing these funds involves specialised research and unique market risks.
Expense ratios for these funds may range from 0.5% to 1.5% for actively managed options and from 0.1% to 0.5% for passive sector ETFs.
Expense ratios vary depending on the type of fund, but benchmarks help identify whether a ratio is reasonable:
To determine if an expense ratio is "good," compare it with similar funds in the same category. For example:
You may want to avoid funds with excessively high expense ratios unless they justify costs through exceptional performance, which is rare.
Even a small difference in expense ratios can lead to significant disparities in portfolio performance over time due to compounding. Here's an example:
Consider two investors, each starting with USD 100,000 and earning a 7% annual return before fees:
After 20 years and considering the compounding effect:
Fees are subtracted from your returns every year, reducing the amount available for reinvestment. Over decades, this compounds into a substantial difference in final portfolio value. Lower expense ratios leave more money invested, maximising growth potential.
Reducing the effect of expense ratios is essential for protecting your long-term investment returns. Minor cost differences can compound into significant sums over time, making it essential to take proactive steps.
Here are a few steps you can take:
Prioritise funds with minimal expense ratios to maximise the investment amount remaining in play. Index funds and ETFs are often the most cost-effective options, with many charging less than 0.1%. These funds provide access to a broad range of markets without the high management costs of actively managed funds.
Sales loads, redemption fees, and other hidden charges reduce your capital and returns. Look for no-load funds or funds that explicitly disclose all costs. Many platforms now highlight these low-cost options, making them easier to identify.
Use fund screeners and calculators to evaluate expense ratios within the same category. For example, compare multiple S&P 500 index funds to find the one with the lowest cost while offering similar performance. Tools provided by investment platforms like Saxo streamline this process.
Larger funds often benefit from economies of scale, allowing them to charge lower expense ratios. These savings come from spreading operational costs across a greater pool of assets. While smaller funds may promise higher returns, they often carry higher costs due to their limited asset base.
Evaluate whether a fund's expense ratio aligns with its potential to deliver returns. A higher-cost, actively managed fund may justify its expense if it consistently outperforms low-cost alternatives. However, only a small fraction of actively managed funds achieve this over the long term, so proceed cautiously.
At first, expense ratios might not seem like a big deal, but over time, these small percentages can quietly eat away at your returns, so understanding and managing them is important.
Choosing funds with low expense ratios—like index funds and ETFs—keeps more of your money invested and growing. Thanks to compounding, even a tiny difference in costs can add up over decades. That's why comparing funds, avoiding extra fees, and sticking with tax-efficient options are so important.
Remember that the less you pay in fees, the more you keep in your pocket. Taking the time to evaluate expense ratios now may significantly impact your long-term financial success.
Quarterly Outlook
Global Head of Macro Strategy
Quarterly Outlook
Chief Investment Strategist
Quarterly Outlook
Global Head of Investment Strategy
Quarterly Outlook
Head of Commodity Strategy
Quarterly Outlook
Global Head of Macro Strategy
Quarterly Outlook
Chief Investment Strategist
Quarterly Outlook
Chief Investment Strategist
Quarterly Outlook
Head of Commodity Strategy
Quarterly Outlook
Global Head of Macro Strategy
Quarterly Outlook
Head of Fixed Income Strategy