Stock Market 101: What is an Expense Ratio?

When you’re new to investing, you’ll probably come across a lot of unfamiliar terms, and one of the most important (but often overlooked) is the expense ratio.

While it might sound like a small technical detail, it can actually make a big difference in how much money you keep in your investment account over time.

Let’s break down what an expense ratio is, how it works, and why it matters for your long-term financial success.

So, What Is an Expense Ratio?

An expense ratio is the annual fee that investment funds charge to manage your money. This fee is expressed as a percentage of your total investment and is automatically taken out of your returns, so you won’t see a separate bill or charge for it, but it’s there.

For example, if you invest $10,000 in a mutual fund with an expense ratio of 1%, you’re paying $100 per year in fees to the fund manager. If the expense ratio is 0.03% (like you might see with an index fund), you’re only paying $3 per year.

What Does the Fee Cover?

The expense ratio covers the fund’s operating costs, which can include things like:

• Portfolio management

• Administrative expenses

• Marketing and distribution

• Legal and accounting services

These costs are necessary to run the fund, but that doesn’t mean you want to overpay for them.

Why Expense Ratios Matter

The reason expense ratios are so important is simple: they reduce your returns.

Let’s say you invest $10,000 in an ETF that earns 8% growth every year but charges a 1% expense ratio annually. Because of the fee, your net return is effectively 7% per year. In the first year, your investment grows by $800 (which is 8% of $10,000), but you pay a $100 fee (1% of $10,000). After subtracting the fee, your ending balance for year one is $10,700.

In year two, you start with $10,700. Your 8% growth adds about $856, and the 1% fee now costs you $107. After fees, you finish the second year with roughly $11,449. This pattern continues each year: the growth amount increases because your balance is growing, and the fee also grows because it’s 1% of the starting balance for that year.

By year five, your investment has grown to around $14,026 after accounting for fees. Ten years later, your balance reaches approximately $19,657. Without the expense ratio fee, that $10,000 would have grown to about $21,589 in ten years at a full 8% growth rate. So, the 1% fee has effectively cost you nearly $1,932 over the decade.

This example shows why expense ratios matter: even a seemingly small 1% fee can shave off a significant amount of your investment growth over time. Choosing funds with lower expense ratios can help your money grow more efficiently in the long run.

When Do You Pay the Expense Ratio?

Expense ratios are charged annually, not just when you cash out your investments.

Here’s how it works: The expense ratio is automatically deducted from the fund’s assets throughout the year. You don’t get a separate bill or payment request. Instead, the fund’s reported net asset value (NAV), which is what you see as the price per share, already reflects the deduction of these fees. So, your investment’s value grows net of those fees continuously.

Because the fees are taken out gradually, you don’t pay a big lump sum when you sell or cash out; the cost is spread out over time, reducing your returns each day or month. That’s why keeping an eye on expense ratios is so important for long-term investing: those small ongoing fees can add up and significantly impact your overall gains.

What’s Considered a “Good” Expense Ratio?

Here’s a general guideline:

• Index funds and ETFs: 0.02% to 0.20%

• Actively managed mutual funds: 0.50% to 1.5% or more

Lower expense ratios are usually better, especially if you’re investing for the long haul.

Where to Find the Expense Ratio

You can find the expense ratio for any fund in its summary prospectus or on financial websites like your brokerage’s fund details page. Always check this number before you invest. Two funds might look similar in terms of performance and risk, but if one has a significantly lower expense ratio, it’s likely the better deal in the long run.

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Expense ratios might seem like a small detail, but they can have a big impact on your long-term wealth. Keeping your investing costs low is one of the easiest ways to boost your returns—without taking on extra risk.

If you're not sure whether your investments are cost-efficient, this is a great topic to bring up with a financial coach. Book a free consultation with one of our experts today and let us help you make smarter, more confident investment choices.