Expense ratio

An expense ratio is the annual fee charged by mutual funds and exchange-traded funds (ETFs) to cover their operating costs, management fees, and administrative expenses. This fee is expressed as a percentage of your investment in the fund. For example, if you invest $10,000 in a fund with a 0.5% expense ratio, you'll pay $50 per year in fees.

Expense ratios can vary significantly between funds, depending on factors such as the fund's investment strategy, size, and management style. Actively managed funds, which rely on professional fund managers to make investment decisions, generally have higher expense ratios than passively managed funds, such as index funds, which aim to track the performance of a specific market index.

Why is understanding expense ratios important? 

Understanding expense ratios is crucial for retirement planning, as these fees directly impact your investment returns over time. Even small differences in expense ratios can add up to substantial amounts when compounded over the course of your working years. By choosing funds with lower expense ratios, you can potentially keep more of your investment returns and maximize the growth of your retirement savings. You can find this information in a fund's prospectus or by using online research tools.

Learn more: What is an average expense ratio?

How do expense ratios affect returns

When a fund has a higher expense ratio, it must perform better than a similar fund with a lower expense ratio to generate the same returns for investors. Over time, even small differences in expense ratios can have a significant impact on your investment growth. This is because the higher expenses eat into the fund's returns before they are distributed to shareholders.

For example, let's compare two hypothetical funds: Fund A with an expense ratio of 0.5% and Fund B with an expense ratio of 1%. Assuming both funds have an average annual return of 7% before expenses, a $10,000 investment in Fund A would grow to $66,144 after 30 years. In contrast, the same investment in Fund B would only reach $57,435 due to the higher expense ratio. That's a difference of $8,709, or 13.7% of your potential earnings lost to fees.

As you can see, choosing funds with lower expense ratios can help you maximize your retirement savings by allowing you to keep more of your investment returns. When selecting funds for your 401(k) or other retirement accounts, it's essential to consider the expense ratio alongside other factors such as investment strategy, risk level, and historical performance. By opting for cost-effective investments that align with your financial goals, you can potentially enhance your long-term wealth accumulation and secure a more comfortable retirement.

How to find funds with low(er) expense ratios

When building your 401(k) portfolio, it's essential to consider expense ratios to maximize your retirement savings. Here are some ways to find funds with low expense ratios:

1. Research and compare expense ratios using online tools and fund prospectuses. Websites like Morningstar, Yahoo Finance, and your 401(k) plan provider's site often provide expense ratio information for various funds. Take the time to compare the expense ratios of different funds within the same asset class to identify the most cost-effective options.

2. Consider index funds and ETFs, which tend to have lower expense ratios than actively managed funds. Index funds aim to track the performance of a specific market index, such as the S&P 500, by holding a portfolio that mirrors the index's composition. Because index funds are passively managed, they generally have lower operating costs and expense ratios compared to actively managed funds.

3. Review your 401(k) plan's fund options and choose the most cost-effective investments aligned with your goals. Your 401(k) plan will typically offer a selection of funds with varying expense ratios. Carefully review the available options and select funds that have low expense ratios while still meeting your investment objectives and risk tolerance. Don't hesitate to ask your plan administrator or a financial advisor for guidance in making your selections.

By prioritizing low-cost funds in your 401(k), you can help ensure that more of your money is working for you, potentially leading to higher returns and a larger retirement nest egg over the long term.

As you compare the available funds, consider a mix of low-cost index funds and ETFs that provide broad market exposure and diversification. These passively managed funds often have expense ratios well below 0.5%, which can help you minimize costs and maximize your long-term returns.

If your plan offers actively managed funds, you may want to periodically evaluate whether their higher expense ratios are justified by consistently superior performance compared to their benchmarks, such as the S&P 500.

What is a good expense ratio

As a general rule, aim for expense ratios below 0.2% for index funds and ETFs that passively track a benchmark. These low-cost funds can be an excellent choice for most investors, as they provide broad market exposure and lower costs, which can significantly benefit your long-term returns.

Actively managed funds, where professional fund managers select investments with the goal of outperforming a benchmark, typically have higher expense ratios. These ratios usually fall around 1%, depending on the fund's investment strategy and asset class. While some actively managed funds may justify their higher fees through strong performance, it's crucial to compare their expense ratios and historical returns to similar funds before investing.