Mutual Fund and ETF Fees: Know the True Cost of Investing

Photo: www.gotcredit.com via Flickr.

Mutual funds and ETFs can be great investment tools -- after all, you can get a ready-made and maintenance-free diversified portfolio in a single purchase. However, you may be surprised at how much the fees associated with mutual funds can vary. And you may be even more surprised at how much of a difference these fees can make over the long run.

How much are you paying in fees?
Mutual-fund fees are disclosed to investors in a number called the "expense ratio." The expense ratio tells you the percentage of the fund's assets that are used to cover operating expenses each year. While the expense ratio is the total of all fees expressed as a single number, here's what it's made up of.

• Management fees: Usually the largest part of the expense ratio, management fees are paid to the fund's managers, who decide how the fund's money should be invested.
• Administrative fees: This covers the other expenses of running the fund, such as office rent, administrative staff, office supplies, and any other expenses.
• Advertising fees: Also referred to as 12b-1 fees, this is the money the fund spends marketing itself to potential investors.

When checking quotes for mutual funds, you'll see two expense ratios listed: gross and net. The gross expense ratio includes all of the fees mentioned above. The net expense ratio shows what investors actually paid during the most recent fiscal year. Many funds offer fee waivers and reimbursements in order to attract investors, so the net expense ratio reflects this.

These numbers are often the same, but in some cases they can be different. Just bear in mind that the gross expense ratio is the important number to look at, as that's the one that determines how much you could end up paying, because waivers and reimbursements can be temporary.

Examples
Mutual fund expense ratios vary significantly, depending on several factors. For example, passive mutual funds that simply track an index tend to have lower expense ratios than actively managed funds, whose managers have to research investments and build a portfolio.

To illustrate this, here are a few popular mutual funds and their expense ratios.

Why it matters
Because a fund's fees are paid out of its assets, high fees can rob you of valuable investment gains. While a small expense ratio may not seem like a high price to pay each year, you may be surprised at how much it can add up over time.

Consider three of the funds from the chart -- the SPDR S&P 500 ETF, the Dodge & Cox Stock Fund, and the JPMorgan Growth Advantage Fund, with gross expense ratios of 0.11%, 0.52%, and 1.36%, respectively. For the sake of this example, let's assume that, in the future, each fund will generate 10% annual returns on average before expenses.

If you invest $50,000 into each of these three funds, take a look at what happens over a 30-year time period.

Of course, this is a simplified example, and different stock funds generally don't produce the exact same returns. And many funds with higher fees could potentially deliver better performance than cheaper funds. For example, the JPMorgan Growth Advantage Fund has a relatively high expense ratio, but also handily beat the S&P 500 over the past one-year, three-year, five-year, and 10-year periods, even after accounting for the fees. However, the example illustrates the point that "small" fees can add up to a meaningful difference over the years.

Just one piece of the puzzle
My point is to make you aware of how much you're paying in fees for your investments. However, it's important to keep in mind that this is only one thing to consider, and a higher fee doesn't necessarily mean you should avoid the fund.

The best thing you can do is to keep expense ratios in mind, especially when comparing similar funds, like two S&P 500 index funds. As we saw from the example, a small difference in fees can mean thousands in additional investment gains over the long run.