What Is an "Expense Ratio"?

By Sherrill St. Germain

Q: When you delivered our financial plan, you talked about wanting to keep our "expense ratios" low. What exactly is an expense ratio, and how does it play into my financial plan?

A: An "expense ratio" is what you pay the managers of the mutual funds you own to research, buy, and sell stocks, bonds, etc., and to perform all the other tasks required to run that business. The actual dollar amount you pay each year is calculated by multiplying the expense ratio (a percentage) times the amount of money you have in the fund. For example, if your account balance is $25,000 and the fund's expense ratio is 1.1%, you pay $275 per year.

Perhaps you're thinking: "Wait a minute! I've never seen a charge like that on my account statement." It's true that these charges never show up on your statement, so many investors are not even aware that they exist. The reason is that the money is taken out of the fund's assets, lowering your ultimate rate of return, but not showing up as a transaction per se. Regardless of how you pay the fee, the result is the same: it's money that is no longer working on your behalf, and it can add up to a lot over time, making it harder for you to meet your financial goals.

As you might imagine, running a mutual fund is a lot of highly specialized work, for which these people absolutely have to be fairly compensated to stay in business offering this service we need. But some companies are more efficient than others, and certain kinds of funds are more efficient than others. And some actually pass these efficiencies on to their investors in the form of lowered costs. So these were the kinds of funds I was targeting when I talked about "wanting to keep your expense ratios low."

Make no mistake: cost is only one of the criteria I consider when recommending a mutual fund. After all, a poor-performing cheap fund is no bargain! But if you do the math, there's no doubt that it makes good sense (no pun intended!) to pay attention to expense ratios.