What are expense ratios? These fees could be eating away at your investment earnings

When it comes to investing, you've likely heard the arguments for putting your hard-earned money into exchange-traded funds (ETFs) or mutual funds to diversify your portfolio or to allocate more of your portfolio toward conservative investments like bonds as you age. Before you begin the investing process and siphon away thousands of dollars for retirement or other future financial goals, there's one term you should absolutely familiarize yourself with: expense ratios.

Expense ratios can eat away at your investment earnings, so it's important to know what they are and how they work. Below, Select takes a look at what expense ratios are, why they're important and how they can vary by fund type.

An expense ratio is essentially a fee that investors pay for the management of a fund — be it an index fund, mutual fund and/or ETF — which includes all administrative, marketing and management fees. Try and think of it this way:

Expense Ratios = the fund's net operating expenses / the fund's net assets

Expense ratios are typically represented as a percentage. An expense ratio of 0.2%, for example, means that for every $1,000 you invest in a fund, you'll be paying $2 annually in operating expenses. These funds are taken out of your expenses over time, so you won't be able to avoid paying them. Just as your returns are magnified because of compound interest, your expenses are as well, which is why there may be a big difference in earnings if you choose to invest in a fund with a high expense ratio.

Let's take a look at this example: You invest $5,000 a year and receive a constant 7% annual rate of return on your investments. According to the chart below, your earnings would be at least $25,000 more if you invested in the fund with a 0.3% expense ratio versus the fund with a 0.6% expense ratio.

Depending on the type of fund you're investing in, expense ratios can vary greatly. Actively managed mutual funds typically have a higher expense ratio than passively managed funds, mainly because passively managed funds don't have managers and researchers who are actively choosing assets to buy and sell.

Over the past 20 years, expense ratios among all funds — including both passive and active — have been trending downward. According to Morningstar's 2020 U.S. Fund Fee Study, the asset-weighted average expense ratio fell to 0.41% in 2020 from 0.93% in 2000. Note that Morningstar uses an asset-weighted average, which weighs funds according to their size.

On the other hand, passively managed exchange-traded funds tend to have low fees since they aim to match the performance of the market, not beat it. The asset-weighted average expense ratio for actively managed funds was 0.62% in 2020 — for passively managed funds, it was only 0.12%.

As far as passively managed funds, index funds are a popular option among investors since they track a specific stock index and aim to match its rate of return. For example, investors can find low fee index funds that track the S&P 500, a popular stock index that tracks the largest 500 U.S. companies based on market capitalization. Fidelity started offering investors 0% expense ratio index funds in 2018.

You can start investing in mutual funds or exchange-traded funds through a retirement account or on your own. Whether you're investing in a Roth or traditional IRA or your employer's 401(k), most retirement accounts provide investors with a variety of options — you may be able to invest in actively or passively managed mutual funds, exchange-traded funds or even individual stocks or bonds. Select ranked Vanguard, Charles Schwab, Fidelity Investments and E*TRADE as the companies offering the best IRAs.

For investors who prefer a more hands-off approach, robo-advisors can be a good choice since they use an algorithm to curate your investment portfolio, periodically buying and selling investments based on your personal financial goals. Robo-advisors typically charge a management fee, which, like an expense ratio, is represented as a percentage.

For example, having an annual management fee of 0.25% means you'll have to pay the robo-advisor company $25 for managing $10,000 of investments. Keep in mind that this fee is charged on top of the expense ratio you'll have to pay for each fund you're invested in. Select ranked Betterment and Wealthfront as the best robo-advisor services.

While investing can be a great source of passive income, if you're unaware of the fees you'll have to pay in the process, you could be earning less money than you think. It helps to be aware of the expense ratio, which includes all administrative, marketing and management fees and is essentially the ratio of the fund's net operating expenses to the fund's net assets.

Actively managed funds typically have higher expense ratios because investors are paying for the potential to have a higher return. In contrast, passively managed funds like index exchange-traded funds typically have lower expense ratios because they only aim to perform as well as the overall market.

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