It seems like spending 1% or even more, annually, for a mutual fund or ETF should be no big deal.  It’s only 1%.  In fact, isn’t this a “you pay for what you get” thing?  Wouldn’t you want to pay a little more for a team of “sharp young fellows” who are crack investors, and deliver a great return for you–an actively managed fund?

Well.  Okay.  If you really want to!

It matters more than it seems.

You need to know about “expense ratios”.  When you buy a fund, you may have a transaction fee.  But beyond that, there is an annual cost to operate a fund.  These companies don’t go out of their way to make this obvious.  You won’t get a statement that says “your fee was $50.”  It is more or less skimmed off the top fairly transparently.  But this information is disclosed publicly if you know to look for it.  If you read a prospectus, this is detailed there.

It takes some work on the part of humans and/or machines to run a fund.  Therefore, yes, there are some costs.  That’s fair, they have to keep the lights on.  The expense ratio is how much the fund company skims off the top to pay for costs and make some profit,.  They don’t do this for free.

Actively managed funds take a lot more work from humans, who like to have salaries, coffee, and such.  They spend a lot of time analyzing individual stocks (or bonds) to make good decisions about which ones the fund should own, when they should buy or sell them, and how much they should pay for them, or sell them for.

Passively managed index funds take much less work.  An external entity determines what stocks are in the index (usually).  The fund just tries to keep up with matching what’s in the index.  That still has some cost, but not nearly as much.

If you have had a few years where a fund makes 10%+, a 1% or more expense ratio may not seem like much.  But over the long haul, your average is probably going to be well under 10%.  Taking a full percentage, or worse, even more, cuts it down further.

What’s even worse is, the margin between your return and inflation is even smaller.  If you earn 7% on average, and inflation is at 3%, that’s only a 4% real return.  So a 1% expense ratio is cutting that off at the knees, knocking your return down 25%.  Compounded over the years, that is a whole lot less wealth for you.

One of the big “total US stock” funds, which hold the entire broad market, often have a razor-thin expense ratios like .04%. That’s pretty amazing.  You can own the whole market, with very little effort, and only pay .04% for that privilege.

More specialized asset classes, such as MicroCaps, perhaps junk bonds, are going to have a higher expense ratios, but you can find them for well under 1%.

A year ago I did the math on my expenses on my 401k at work.  How I did this was to take the balance of each fund and multiply it by the expense ratio.  I was shocked at how much money was being spent on them.  I was able to persuade my company to provide a bigger selection of low-cost index funds, and now I am nearly all in such funds.

You should always check your funds expense ratio’s.  A site like Morningstar will show you the expense ratio, as well as a lot of other information about the fund.  Here’s an example of Morningstar’s quote for VTI, Vanguard’s Total Market fund: VTI.  The expense ratio is .05%.

Checking for a low expense ratio is a very important component of low-cost index investing.

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