What are expense ratios? And how can you potentially add an extra $1,000,000 in your pocket? Find out here!
In this article
Guys and Gals!
Over the weekend, I’ve been doing some research as it relates to how I should allocate my money in the stock market.
For me, once I invest in the stock market, I don’t get out of the stock market.
That money will be in the stock market until I retire (so roughly for another 45 more years).
I’m sure you can tell that I am a long term investor.
And you should be one too.
Let’s say I did successfully convince you to become a long term investor.
There’s one other item I need you to consider before beginning to invest your hard-earned money in the stock market.
And that is keeping an eye on expense ratios.
What is an expense ratio?
An expense ratio is a number that is designed to measure how much of an investment fund’s assets are attributed toward various expenses.
In English: an expense ratio essentially refers to how much of your invested money will be going toward the investment fund’s expenses versus how much of your money will stay invested and continue to grow.
The higher an expense ratio, the lower your (the investor’s) overall return on investment.
(Also known as ROI).
Easy expense ratio example
The first time I was introduced to the term “expense ratio” was as I was looking through my 401(k) plan investment options.
If you have a 401(k) plan or simply are investing in an IRA or another type of investment account where you can select your stocks, stay with me.
As I was looking through the many different types of investment funds I could invest my money in, next to the “Fund Performance” column, I saw this column titled “Net Expense Ratio.”
Being new to the financial services industry, I thought I was reading Pig Latin.
I didn’t know what “Net Expense Ratio” meant. How should I have?
How should you know?
Well, after asking the Chief Investment Officer of my company, I finally found out what it meant.
He explained that an expense ratio essentially tells the investor how much of their invested money will be going into the pockets of the investment fund managers.
These are the people who are managing the investments I was selecting to invest my money.
Here’s an example: the Chief Investment Officer of my company pointed out two investment options that were pretty similar in terms of allocation.
(This means, they were both fairly heavily invested in stocks. Given my age back then, I could afford to be invested in more stocks than bonds).
One investment indicated an expense ratio of 1.25%.
To me, that seemed pretty cheap. I didn’t think much of it.
The second investment indicated an expense ratio of 0.03%. Comparing the two numbers showed me that the 0.03% expense ratio was the “cheaper” option.
Given that both investments were roughly similar, we decided to invest my money in the fund with the lower expense ratio – because that ultimately meant more money in my pocket.
Although I didn’t realize how much money was in my pocket until I found out why exactly analyzing expense ratios is so important for your future wealth.
Read on below, to find out why…
Why it’s the best kept secret
Guys and Gals,
This simple secret blew my mind.
And I’m pretty sure it will blow yours as well.
Let’s say you have the option to invest in a fund with a net expense ratio of 0.65% and you have the option to invest in a similar fund with a net expense ratio of 0.15%.
What’s your first step?
Yes, you’d want to see which fund has the lower expense ratio – and that is the one with the 0.15% expense ratio.
Next, notice the difference between the two net expense ratios: 0.50%.
That’s half a percent difference. That’s a lot.
This is what I learned as I picked the brains of former Wall Street hedge fund managers.
Over 30 years of consistently investing in the same product, an expense ratio difference of 0.50% or more can make a difference of over $1,000,000 in your pocket over that time frame.
Let me repeat that: a 0.50% expense ratio difference over 30 years will make over a $1-million-dollar difference.
What does that mean for you?
That means if you look for low expense ratio investments today and continue to invest in these “low cost” investment funds, you will likely wind up with an “additional” $1 million over a 30-year time frame.
(This is assuming you continue to add money to this investment over the 30-years, allowing that money to compound and that you do not withdraw money from this investment during this timeframe).
Maintaining a low expense ratio will do you wonders – in the long run.
And when I heard the million-dollar number, I was in awe and swore to myself to research.
Expense ratios found in index / passively managed funds vs actively managed funds
I thought it might be interesting to do a quick case study and dissect the expense ratios of an index fund.
(Which oftentimes is a passively managed fund) versus an actively managed fund.
What is a passively managed index fund?
As a quick refresher, a passively managed investment fund describes an investment fund that is not managed on a day to day basis.
This investment product just follows the market – and often does not have a team of professionals making investment decisions for that investment fund.
Because a passively managed investment fund does not have an active management team behind the scenes making the calls, typically these types of investments are cheaper.
(Meaning a lower expense ratio) than the actively managed funds.
By contrast, an actively managed fund is an investment fund that has a team of professionals managing the fund in the background.
They research this fund night and day, making active selections and choices on how to improve the investments within this fund.
Because so much work goes into the make-up of this investment fund, it is called an actively managed fund – and often has a higher expense ratio than a passively managed fund.
For example, if you look at an S&P 500 Index Fund (Which is an example of a passively managed investment fund).
You’d likely expect to see expense ratios ranging from somewhere around 0.03% to about 0.3%.
On the other hand, if you are considering an actively managed investment fund with a similar allocation to that of the S&P 500, you’d likely be looking at an expense ratio of about 0.9% to 1.5% or more.
See the difference?
The highest expense ratio I’ve seen in my life was over 3%.
I was outraged when I saw that investment managers got away with charging this amount to clients!
It’s like white-collar crime – and how is the average person supposed to know that they need to look for the expense ratio to determine the cost of an investment product?
That’s why I hope with this blog post, I’m able to put some more money in your pockets as you start your investment journey!
Where can you find the expense ratio of a potential investment fund
Now that we’ve taken some considerable time to discuss what expense ratios are, let’s talk about how you can research the expense ratios of an investment product.
For starters, if you are enrolling in a 401(k) plan and you have the investment fund selection sheet in front of you, there typically should be a few columns next to the individual investment fund options.
These columns will typically indicate the fund performance over the past year or the past few years and the columns also typically indicate the expense ratios of each investment fund option.
If you do not have a 401(k) plan and are simply looking to invest in either your IRA or another investment account, a great website to research the net expense ratios of essentially any type of investment fund is known as Morningstar.
This is a website that the pros use as well to research varying investment fund metrics.
Don’t get overwhelmed by the amount of information offered on this site, I would suggest simply search for the expense ratio of an investment product you are searching for.
Assuming you are using Morningstar as your research tool, here’s what you have to do:
- Type in the name of your investment fund (or you can also type in the ticker symbol of the investment fund in the quote/search bar at the top of the page).
- Make sure you landed on the “quote” page under your researched investment product.
- Scroll down to “expense ratio” or “adjusted expense ratio.” (An adjusted expense ratio could be more consistent when comparing other funds, but both numbers are typically the same).
This feature is free – to all users.
I would suggest that the number one item to consider as you begin on your investment journey is making sure you have a firm understanding of how much money you are paying the investment fund managers.
AKA the people behind the scenes of the investments you are selecting.
Over time, the expense ratio can make or break your wallet.
Remember, if you consistently invest in an investment option over 30 years, a difference of 0.50% can make up to a $1,000,000 difference in your pocket.
Do your research before committing to an investment product.
And chances are, if you consider investing in a passively managed fund, you’ll likely encounter lower expense ratios.
Your bank accounts will thank me later!
Have you had experience with expense ratios? If so, comment below!