You’ve probably seen offers to buy now and pay later when shopping online. Instead of making a high upfront payment for a product, these services let you make tiny payments each month. But, of course, everyone eventually discovers that these ‘small’ payments add up to much more than the original product’s cost.
Similarly, investment fees may seem small at first glance. After all, what’s the difference between a fund that charges 0.05% and 1%? It turns out, quite a lot. On a $100,000 investment over 30 years, this seemingly tiny difference could cost you more than $100,000 in lost returns. That’s enough to fund several years of retirement or pay for college!
The good news? Fund expenses aren’t complicated once you know where to look. Think of them like the ingredients list on a food label—they might be printed in small text, but once you learn to read the label, you’ll know exactly what you consume.
In this guide, we’ll walk through everything you need to know about fund expenses in plain English to help you understand what you’re paying and how to find better deals.
Breaking Down Expense Ratios
Think of expense ratios as the price of having professionals manage your money. It’s the total percentage of your investment that goes toward running the fund each year. So, when you see an expense ratio of 0.2%, that means you’re paying $2 for every $1,000 you invest—and this money goes directly out of your returns regardless of performance.
These fees cover the costs of running a fund. The largest portion typically goes toward paying portfolio managers that make investment decisions and their research teams. There are also administrative costs to cover things like customer service reps, the technology to track trades and retain records, and the cost of sending statements and tax forms.
You might notice funds listing both a ‘gross’ and ‘net’ expense ratio. The gross ratio is the natural cost of running the fund, while the net ratio reflects what you pay after any fee waivers or reimbursements. While ‘net’ expense ratios are what you ultimately pay, you should keep in mind those waivers can expire.
Understanding Funds of Funds
Many retirement portfolios contain ‘funds of funds’—or mutual funds that hold other mutual funds. In this case, you’re usually paying expenses for each underlying fund plus an additional layer of fees for the manager who picks and monitors those funds. The result is known as ‘expense stacking’ and can significantly impact your returns.
The most common example of this is target date retirement funds. When you invest in one of these funds, you’re typically buying a mix of eight to ten other funds. Each of those funds has its own expense ratio, although they may reduce or waive these fees if the funds belong to the same investment firm—but not always.
You should look for ‘acquired fund fees’ or ‘underlying fund expenses’ in the prospectus for these funds to understand the total expenses. A seemingly cheap fund of funds charging 0.2% might cost 0.85% when you include all underlying expenses. Whether that’s worth it depends on the performance and how it fits within your portfolio.
Getting the Complete Picture
Let’s break down exactly how to calculate what you’re paying and how it affects your long-term returns, using straightforward math and spreadsheets.
Calculating Annual Costs
To find out what you’re paying, use this simple formula:
- Take your investment amount (say $100,000)
- Multiply it by the total expense ratio as a decimal (0.50% becomes 0.005)
- Add up the totals for each fund in your portfolio
Using this information, you can assess whether you want to manage your own portfolio of stocks versus relying on a professional manager or whether you should look at cheaper alternatives to some funds within your portfolio given the dollar amount invested.
Comparing the Impact of Expenses
To estimate the lifetime cost of any fund, use this simplified formula:
- Take your investment amount
- Multiple by the expense ratio
- Multiple by 25 (roughly estimates the impact over 30 years)
Using this formula, it’s easy to see why even small fee differences matter enormously over time. It’s why the decision between a 0.04% index fund and a 0.5% active fund isn’t just about saving 0.46%—it’s about keeping tens of thousands of dollars in retirement.
The Bottom Line
Investment costs are like a slow leak in your financial plumbing—they seem minor at any point in time, but when you zoom out, they can drain away a significant portion of your wealth. While every fund needs to cover its costs and self-management isn’t right for everyone, vigilant expense management is a good idea for every investor.
