Here’s How Expense Ratios Impact Your Investment Returns

Fact checked by Yarilet Perez
Reviewed by Pamela Rodriguez

For mutual fund and exchange-traded fund (ETF) investors, expense ratios are an important but sometimes overlooked element that can have a real impact on long-term returns.

The expense ratio is the annual charge that a fund imposes on its shareholders. It covers operational costs, such as portfolio management, overhead, administration, and marketing expenses.

Expense ratios of 0.25% or 0.50% may seem small, but they can accumulate into thousands of dollars in fees over decades-long investment periods. Knowing the role they play in your returns over time is thus crucial.

Key Takeaways

• Mutual funds and ETFs charge their shareholders an expense ratio to cover operating and distribution costs.
• Even seemingly low expense ratios can drag down total returns over a long-term investment horizon.
• Index funds, which are passively managed, typically have much lower expense ratios than actively managed funds or those invested in less tradable assets.
• The long-term trend has been toward lower expense ratios, although some funds still charge upward of 2%.

Why Are Expense Ratios Important?

A fund’s expense ratio is essentially the cost of admission for participating in a professionally managed investment vehicle. It’s given as a percentage of the amount you’ve invested and is deducted from your returns automatically, so it’s not like you’ll get a separate bill.

While many investors focus exclusively on performance figures, they may not realize how much these ongoing fees eat into their returns year after year. Investors should thus pay close attention to them:

1. They directly cut into your returns: Every dollar paid in fees is a dollar less in your account that won’t grow over time. Higher expense ratios mean you keep less of your overall investment gains.
2. Compounding effect: The impact of fees compounds over time, just as your returns do. A seemingly small difference in expense ratios can translate to significantly different outcomes over several decades.
3. Indicator of fund type and strategy: Expense ratios will often reflect a fund’s management style. Actively managed funds or those invested in more obscure or less liquid asset classes will tend to have higher expense ratios, while passively managed index funds typically have much lower fees.
4. Predictable and transparent: Unlike market performance, which is inherently unpredictable, expense ratios are known in advance and are one of the few investment factors you can control.

How Is the Expense Ratio Calculated?

Here is the expense ratio formula:

Expense Ratio = Total Fund Operating Expenses / Average Net Assets

A fund with operating expenses of $1 million and assets of $100 million would thus have an expense ratio of 1%.

Components of Expenses Ratios

Understanding what goes into a fund’s operating expenses can help investors make more informed decisions. These expenses typically include:

• Management fees: The management fee covers the portfolio managers and their teams, who are responsible for making investment decisions, and is often the largest part of the expense ratio (between 0.10% and over 1%). Actively managed funds require higher fees because they cover additional expenses related to research, analysis, and active trading in the markets.
• 12b-1 fees: SEC rules allow for 12b-1 fees that cover marketing and distribution expenses. These fees typically range from 0.25% to 1%, and are more common in mutual funds designed for retail investors than ETFs or funds targeting institutional investors.
• Administrative costs: This covers recordkeeping, customer service, legal, and accounting costs.
• Trading costs: Investors bear the costs related to trading activities in the fund’s portfolio, even though these costs do not appear directly in the expense ratio. Even with today’s low-commission environment, funds with high turnover ratios have higher trading expenses and more taxable events that flow down to investors.
• Other expenses: The fund’s other expenses may cover custodial fees, auditor fees, and compensation for the board of directors.

Funds determine their expense ratio once a year using the previous fiscal year’s operating costs and average asset values. Investors pay for the expense ratio in daily increments applied to the fund’s net asset value instead of a lump sum payment for the entire annual percentage.

Types of Funds and Their Expense Ratios

Different types of funds have vastly different expense structures:

Effect of Expense Ratios on Investment Returns

The impact of expense ratios becomes evident when examining long-term investment returns. The chart below shows how different expense ratios affect investment growth over time. Our example uses a consistent 10% gross annual return on an initial $10,000 investment:

After accounting for the compounding effect of these fees over 20 years, when the expense ratio is 0.05%, the investment grows to about $66,666, with about $285 paid in fees over time. When the expense ratio is 0.5%, the investment grows to about $61,416, with about $2,706 in fees. But with a 2.5% expense ratio, the investment grows to only about $42,479, with about $10,826 paid in fees.

Expense Ratio Trends

The good news for investors is that expense ratios have been decreasing because of growing competition among fund providers and other changes that have lowered overall expenses. For instance, improved operational efficiencies have helped fund providers reduce administrative costs.

There are also economies of scale. As funds’ asset bases continue to grow, fixed costs (such as transfer agency fees or accounting fees) represent a smaller proportion of total expenses, resulting in a lower overall expense ratio. In addition, investors have become more cost-conscious. It’s certainly easier to find this data than a few decades ago—they’re increasingly choosing lower-cost options, putting additional pressure on high-fee funds.

According to the Investment Company Institute, the average expense ratio for equity mutual funds has declined from around 1% in 2000 to 0.40% in 2024. For index equity ETFs, the average has fallen to 0.15%.

Despite positive trends toward lower expense ratios, some funds—particularly those sold through certain advisor channels or included in retirement plans with limited options—still charge high fees relative to the services provided.

The Bottom Line

Long-term investors should minimize expense ratios whenever possible to maximize their total returns. Compare fees among similar mutual funds or ETFs since even small percentage differences in this fee can quickly add up to significant costs over time.

The best investment choice doesn’t always mean selecting the cheapest fund available in every category, but funds with particular strategies might justify slightly higher costs. Investors should monitor their expenses and verify that elevated fees are warranted by the fund’s returns.