The real cost of expense ratios: Are you wasting money?

Expense ratio examples across different fund types

Expense ratios vary depending on the type of fund, its management style, and the complexity of its investment strategy.

Index funds and ETFs

• Expense ratio range. 0.02% – 0.25% (some specialised ETFs exceed 1%)
• Reason. Passively managed, tracking a market index with minimal trading activity.
• Example. Broad-market ETFs, such as S&P 500 index funds, often charge as little as 0.02% – 0.05%, making them one of the most cost-effective ways to invest. However, leveraged or niche ETFs can have expense ratios of 0.5% – 1.5%.

Actively managed mutual funds

• Expense ratio range. 0.75% – 1.5% (some specialised funds exceed 2%)
• Reason. Higher costs due to active stock selection, research, and frequent trading.
• Example. Actively managed equity funds typically charge 1% or more, which can significantly reduce net returns over time. Emerging-market and small-cap funds can have fees exceeding 2% due to higher transaction costs and research-intensive strategies.

Sector and thematic funds

• Expense ratio range. 0.5% – 2.0%
• Reason. These funds require specialised research and may have higher turnover rates.
• Example. Technology or healthcare-focused funds often carry higher expense ratios than broader market index funds, reflecting the additional research and active management involved.

Hedge funds and private equity

• Expense ratio range. 2% + performance fees
• Reason. Complex investment strategies, high research costs, and performance-based compensation structures.
• Example. Hedge funds often follow a '2 and 20' model (2% annual fee + 20% of profits), while private equity funds charge similar fees but may include additional costs for deal structures and profit-sharing.

Some funds temporarily waive a portion of their fees to attract investors. The gross expense ratio reflects total fees before waivers, while the net expense ratio shows what investors actually pay after discounts. Always check how long waivers last to assess long-term costs.

Are high expense ratios ever worth it?

A high expense ratio does not always mean poor value. In some cases, funds justify higher costs by delivering superior risk-adjusted returns, unique investment strategies, or access to specialised markets.

Here are a few cases when higher expense ratios might be justified:

Consistent outperformance

Some actively managed funds have a track record of beating their benchmarks net of fees, though not all sustain this long term.

Access to niche markets

Funds investing in emerging markets, small-cap stocks, or alternative assets often have higher fees due to greater research and transaction costs.

Risk management & specialised strategies

Due to complex risk management and unique investment approaches, hedge funds, private equity, and tactical asset allocation funds charge higher fees. However, these fees should be assessed based on risk-adjusted return metrics, such as the Sharpe ratio and Sortino ratio, rather than just absolute returns.

How to compare and evaluate expense ratios

Comparing expense ratios across funds helps investors identify cost-effective options without sacrificing performance. A slight difference in fees can translate into significant savings over time, making proper evaluation essential.

Here are a few practical steps to follow:

1. Use an expense ratio calculator

Use an expense ratio calculator to estimate how fees reduce investment growth over time. Ensure the calculation accounts for compounding returns and investment horizon.

2. Benchmark against industry averages

Compare fees against both category averages and low-cost alternatives (e.g., index funds). For example, if an actively managed US large-cap equity fund charges 1.2%, but a passive S&P 500 ETF costs 0.03%, investors must determine whether the 1.17% difference is justified.

3. Examine the net vs gross expense ratio

The net expense ratio reflects what investors actually pay after fee waivers.

4. Analyse historical performance vs fees

Funds with higher fees should justify their cost through sustained, long-term, risk-adjusted outperformance. Use metrics like the Sharpe ratio and Sortino ratio to assess if returns compensate for higher fees.

Red flags to watch out for:

• Expense ratios significantly above category averages. These should raise concerns unless the fund has a proven record of consistent, risk-adjusted outperformance.
• 12b-1 fees and unnecessary charges. Some funds include marketing and distribution fees that add costs without providing extra value.
• Declining fund performance. A once-strong fund with increasing fees and poor returns may no longer be worth the cost.

Strategies to reduce the impact of expense ratios

Even minor differences in expense ratios can lead to significant reductions in long-term investment gains. While fees are unavoidable, investors can take proactive steps to reduce their impact and maximise portfolio growth.

Prioritise low-cost index funds and ETFs

Index funds and ETFs are among the most cost-efficient investment vehicles available. Unlike actively managed funds, which require teams of analysts and frequent trading, index funds simply track a benchmark, keeping costs low.

For example, broad-market ETFs, such as an S&P 500 tracker, can have an expense ratio as low as 0.02%, while actively managed mutual funds often charge 0.75% – 1.5%, with some exceeding 2% in specialised sectors. Over time, these cost differences can translate into thousands of dollars in savings.

Avoid funds with 12b-1 fees and unnecessary charges

Some mutual funds include marketing and distribution fees—known as 12b-1 fees—that add to overall costs without improving performance. These fees are embedded within the expense ratio and can be as high as 1%.

Investors should carefully review a fund's prospectus to identify unnecessary fees and opt for funds that minimise administrative and marketing costs. Many leading investment platforms now offer no-load, low-cost mutual funds that eliminate these extra charges.

Consolidate investments on low-fee platforms

Brokerage and investment platforms sometimes impose additional fees beyond a fund's expense ratio. These can include account maintenance fees, platform fees, or transaction costs.

By consolidating investments with a single low-cost provider, investors can often qualify for reduced fees, especially as their portfolio size increases. Many modern brokerages offer low commission and account maintenance fees, further reducing investment costs.

Consider direct indexing as an alternative

For investors with larger portfolios, direct indexing provides an alternative to ETFs and mutual funds by allowing them to purchase individual stocks that make up an index. This eliminates the need to pay expense ratios entirely while still gaining diversified market exposure.

While direct indexing requires more active management and may involve trading commissions, the long-term cost savings can be significant, especially for high-net-worth investors.

Conclusion: Why expense ratios shouldn't be ignored

Expense ratios may initially seem insignificant, but their long-term impact on portfolio performance is undeniable. These fees are deducted automatically, reducing investment returns year after year. Even a small percentage difference can compound into substantial losses over decades.

Investors who actively compare fees, avoid unnecessary charges, and explore cost-efficient alternatives stand a much better chance of maximising their long-term wealth. A fund with a high expense ratio must consistently deliver superior risk-adjusted returns to be worth the extra cost. If not, lower-cost alternatives can provide similar market exposure without the drag of excessive fees.

Overall, minimising costs is one of the few aspects of investing entirely within your control. Keeping fees low allows compounding to work more efficiently, preserving your capital and optimising your returns over time.