What Is a Mutual Fund Expense Ratio and How Does It Affect Returns?

Knowing the expense ratio could change your opinion of a fund.

Diversification is important, but if you only have a few hundred or thousand dollars to invest, it can be hard to invest in a range of companies. Even if you have enough money to buy a few shares of ten or more companies, your trading costs can eat away at any gains. Investing in a mutual fund allows you to pool your money with others and invest together. But a company has to manage the money in the mutual fund, and it passes on the costs of administering the mutual fund to you in the form of an expense ratio.

Keep reading and learn the basics before you invest in mutual funds.

Mutual Fund Expense Ratio

A mutual fund’s expense ratio compares how much the company charges investors as a percentage of the fund’s net assets. The expenses include:

  • Costs of managing the mutual fund’s portfolio
  • Administrative expenses
  • Marketing
  • Distributions

You won’t see the expenses taken out of your investment as a line item, because the expenses just reduce the value of the mutual fund. Check the mutual fund’s prospectus to find the percentage you’re paying.

Compare: Here Are the 20 Best Mutual Funds

How Mutual Fund Expense Rations Affect Returns

The expense ratio reduces the return on your investment because the fees lower the value of your interests in the mutual fund. When expense ratios are higher, it’s harder for the fund to outperform the market as a whole. If one mutual fund charges you 1 percent, that means you need a 1 percent return just to break even each year. Over time, these small differences can add up.

For example, Mutual Fund X charges 0.62 percent and Mutual Fund Y charges 0.12 percent. If you invest $25,000 for 10 years, you would pay:

  • $534 for Mutual Fund Y
  • $2,700 for Mutual Fund X

Mutual Fund Fees

Read the prospectus for any mutual fund you are considering to determine how much you will pay in fees when you’re deciding how to invest your money. In addition, actively-managed mutual funds will have higher fees than passive funds, like index funds.

Don’t get caught up in looking at only the expense ratio. Different types of funds can have different expense ratios. For example, large-cap equities are widely traded, so expenses are generally low. But, if you want to invest international equities, expense ratios are often higher because the funds need a staff to keep track of how companies are doing around the world. Plus, an international fund might also be hedging with investments in international currencies.

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