Ep. 43: Expense Ratios & Why They're Important

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Welcome back, my name is Michael Colby and I’m here to help guide you in becoming a better and more confident investor. I’ll continue to stand by the fact that we are in a renascence when it comes to the financial planning industry. Things are not what they used to be and things are changing fast. The industry is becoming more transparent and easier for investors to get involved and take control. You as investors and consumers are becoming more educated than ever before, and with that consumers are demanding better service and products or investments in their portfolios. I find there’s a lot that goes into a quality product or investment solution, but one thing for sure I think we can all agree on is the price of the product is important. And that’s why in this episode I want to get into expense ratios! What are they? What do they tell us about the fund or investment you’re using? And why you should care about this… and with that being said, let’s get into this week’s episode of Money Matters.  

The expense ratio sometimes referred to as the management expense ratio, measures how much of the fund’s assets are used for administrative and other operating expenses. You find out how much you’re paying for this expense ratio by dividing a fund’s expense ratio or operating expenses by the amount of money you have invested in the fund. For simplicity say you have a $100 investment in a fund. IF that investment’s net expense ratio is 1% then you pay $1 annual to that fund for operating expenses. Now if you’re not sure if you pay this fee that understandable as it’s often overlooked. If you’re investing in an ETF or Mutual fund you’re almost certainly paying this fee. However, the charge is not paid by you, the shareholder to the fund company. Instead, the expense ratio is taken directly from the value of the fund which is reflected in the fund’s daily Net Asset Value also known as the fund market value per share. So essentially you are the investor who is indirectly paying this expense ratio through the value of your investment. As the return on your investment that you see is already reduced by operating cost this ratio reflects.

The expense ratio is usually going to be expressed as a percent. Or as they’re referred to in the Financial Services Industry as basis points. Basis points are a fraction of a percent. So 25 basis points equates to .25 of a percent. So if you have an investment with an expense ratio of .25 or 25 basis points that means for every $1000 you invest in this fund, the company will be taking out $2.50.

With this knowledge in mind, you may be tempted to simply pick the fund with the lowest expense ratio and go on with your life. I do very much feel the cost is important when selecting your investments, it’s certainly not the end all be all. Here are some things to keep in mind when you’re finding suitable investments with the expense ratio in mind.

Actively and passive investment. Actively managed ETF and mutual funds are going to have higher expense ratios than passive investments. Which makes sense as they are actively managed they have more buying and selling going on in the fund which is going to drive up management cost. My philosophy on this is, if the cost of active management is actively beating the benchmark, then that’s fine, otherwise, I would question what it is I’m paying for.

Don’t put two investments into a fund screener for comparison and then simply pick the investment that’s a fraction more affordable. I know this is tempting, but take the time to look into the underlining holding and their weightings to those holdings. That’s ultimately what’s going to make you successful with your investment. Not a few basis points here or there.

Don’t get hung up on the Net Expense Ratio and overlook the other costs. The expense ratio does not include every fund cost nor any of the costs associated with hiring a wealth manager. The expense ratio is the annual cost of owning the fund.  As such, any brokerage costs, sales loads, transaction fees, advisory fees, and any other charges passed on to investors aren’t reflected in the expense ratio and are something you should be informed about.

And as always consider your goals and the big picture. Are these investments going to get me closer to my goals? Make sure you’ve explored similar strategies and products that will get you closer to your goals in a more cost-efficient manner. Are these products the best for you, or are they paying your advisor the most? Whose best interest is being served with this investment?

Now that you’re armed with this knowledge make sure you’re asking questions. Here at Colby Financial Guidance, we pride ourselves on transparency and communication when working with those in the Rochester community who choose to partner with us. As an investor, you should never feel shy or intimidated about asking your financial advisor to explain something that you’re having trouble understanding. We encourage our clients to do so because we feel more our clients understand why these are the investment we recommend, they are then more engaged and confident in understanding the big picture as we work together to achieve their goals. Thank you for watching and as always thank you for giving your finances the attention that they deserve.