4 key investment strategies for beginners | CNN Underscored Money
4 key investment strategies for beginners · 1. Active and passive investing · 2. Buy and hold · 3. Dollar-cost averaging · 4. Invest in index funds.
expense ratios
Index funds also provide a simple and effective way to diversify your portfolio. “They offer broad market exposure, reducing the risks associated with individual stock selection,” said Scott McBrien, founder and chief investment officer at The Laser, a stock market technology company based in Scottsdale, Arizona. “Index funds are also cost-effective, with lower <anchor>expense ratios</anchor> than actively managed funds, and provide an easy entry point for beginners to gain broad market exposure.”
What is an expense ratio? | CNN Underscored Money
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# What’s an expense ratio?

By

Evan Cooper


[Paul Curcio](https://www.cnn.com/cnn-underscored/about/paul-curcio)

[David Tony,](https://www.cnn.com/cnn-underscored/about/david-tony)

CNN Underscored Money


Published 11:00 AM EDT, Fri February 9, 2024

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Mutual funds and exchange-traded funds (ETFs) are extremely popular pooled investment choices that provide easy access to an array of diverse, professionally managed investments. Businesses known as investment companies — which create, manage and market mutual funds and ETFs — incur costs in providing those services.

The total of an investment company’s costs for each fund, which is borne by that fund’s shareholders, is expressed in a number known as the fund’s expense ratio.

## How expense ratios work

Regulated by the Securities and Exchange Commission (SEC), investment companies are the specialized businesses that create and operate [mutual funds and ETFs](https://www.cnn.com/cnn-underscored/money/etf-vs-mutual-funds). There are many costs that investment companies bear when creating and then operating a mutual fund or ETF, all of which factor into the expense ratio that shareholders must pay to own one of these funds.

First, there is the initial legal expense of creating a fund to conform to SEC rules. Then, there are the ongoing expenses of complying with SEC rules, reporting results to the SEC and providing shareholders with required legal documents. There is also the expense of managing a fund’s investments, which can include the cost of research and analysis to determine which securities to buy or sell, as well as the trading commissions involved when the fund buys or sells securities for its portfolio. Finally, there is the cost of marketing the fund and communicating with shareholders.

## How is an expense ratio calculated?

Once a year, a fund’s managers add up all the administrative and operating expenses they incurred in connection with running the fund, including their fee for managing the fund, and then divide that sum by the average value of the assets in the fund for the preceding year. The resulting number is the expense ratio, which is expressed in percentage terms.

An expense ratio of 0.5%, for example, means that a shareholder whose fund shares are worth $10,000 would pay $50 annually to the investment company operating the fund. But instead of having shareholders write a check, investment companies deduct the dollar amount of the expense ratio from the fund itself, which reduces the fund’s assets by that amount. Every fund, therefore, produces two rates of return: a gross rate of return that doesn’t take into account the expense ratio and the lower net return, which does. It is the net return that investors receive.

Funds must disclose their expense ratios in their [prospectus](https://www.investor.gov/introduction-investing/investing-basics/glossary/prospectus), the brochure or booklet each fund must provide to prospective buyers that outlines a fund’s investment strategies, risks and other information about the fund, including the experience of its managers. Expense ratios also are included in the information found online from investment companies, media companies and fund screening tool providers.

## How do expense ratios affect returns?

Because a fund’s expenses are deducted from its value, the higher the expense — and the expense ratio — the lower a fund investor’s net return.

To help you visualize what a dramatic impact a fund’s expense ratio can have on the growth of your investments over time, examine the following chart showing the hypothetical growth of $10,000 at a 5% annual rate of return and 1%, 0.5% and 0.05% expense ratios:

When considering a mutual fund or ETF, therefore, a potential investor should consider the fund’s expense ratio and check to see if it is higher or lower than the expense ratios of comparable funds. If a fund’s net return after expenses is still attractive despite a higher expense ratio vis-à-vis comparable funds, the fund may be worth considering.

## Expense ratios: Actively versus passively managed funds

[Mutual funds](https://www.cnn.com/cnn-underscored/money/how-to-buy-mutual-funds) generally fall into [two camps](https://www.cnn.com/cnn-underscored/money/alpha-vs-beta-investing): those that are actively managed and those that are passively managed. Actively managed funds employ researchers, analysts and portfolio managers who use a variety of techniques, including analyzing company performance and/or stock market trading patterns to assess the future performance of a security. Active managers often specialize in a particular specialty niche, such as international stocks, small-company stocks or municipal bonds.

Managers of passively managed funds, in contrast, simply match a fund’s holdings to a [stock market index](https://www.cnn.com/cnn-underscored/money/stock-market-basics). A mutual fund based on the widely followed Standard & Poor’s 500 stock index, for example, would contain all the stocks in the index in the same proportion (which is based on each company’s market value). The managers of so-called [index funds](https://www.cnn.com/cnn-underscored/money/low-cost-index-funds), therefore, only change their fund’s portfolio when Standard & Poor’s makes a change to its index, such as when it removes one company in the S&P 500 and replaces it with another, which only occurs occasionally.

Because the cost of operating an actively managed fund is much higher than the cost of simply following an index — largely because employing a team of knowledgeable investment professionals is expensive — actively managed funds tend to have higher expense ratios than passive funds or ETFs. According to the [Investment Company Institute](https://www.ici.org/news-release/23-news-expense-trends), the average expense ratio for actively managed equity mutual funds was 0.66% in 2022, and the average expense ratio for index equity mutual funds was 0.05%.

ETFs, which are structured differently from mutual funds, tend to be passively managed and follow popular indexes, although the number of actively managed ETFs has grown in recent years. The expense ratios of most equity ETFs, therefore, are lower than those of actively managed equity mutual funds, although a bit higher than index mutual funds. The average equity ETF expense ratio in 2022 was 0.16%, the Investment Company Institute determined.

Competition has driven down expense ratios in recent years, which has been a boon for investors. As the graphic above shows, even small differences in what seem like tiny expense percentages can add up to big differences in investor wealth over the long term due to the impact of compounding. Today, an expense ratio over 1% is considered high.

## Frequently asked questions (FAQs)

How does an expense ratio affect my investment returns?

The higher a fund’s expense ratio, the lower the investment return to the fund’s owner. When choosing between two hypothetical funds with identical gross returns, the one with the lowest expense ratio will outperform because it returns more of its gains to investors. Funds in asset classes that are less liquid and/or require specialized expertise to manage — such as international funds that maintain staff around the world — often have higher expense ratios, which may or may not be offset by greater performance.

Are higher expense ratios justified for actively managed funds?

There is no getting around the fact that active management is more costly than operating a fund that passively mimics a predetermined index. The argument made by active managers is that investors get what they pay for, which in the case of active management is manager expertise that can lead to outperforming the market. History has shown that while outperformance isn’t rare, any one fund’s outperformance rarely occurs consistently over extended periods. Many investors are content with the low expense ratios of index funds in exchange for receiving returns in line with market performance. Academic studies have confirmed that if investors ignore market ups and downs and stick with a low-cost investment program that tracks overall market performance, they invariably do better than trying to pick winners and losers.

How can I find the expense ratio of a mutual fund or ETF?

The expense ratio must be disclosed in a fund’s prospectus. All major financial websites and fund screening services also include the expense ratio in the data they provide about each mutual fund and ETF.

What are the other costs associated with investing besides expense ratios?

Expense ratios indicate how much investors are paying for all the services that the investment company provides in running the fund. Commissions and/or fees in connection with buying, selling and holding funds and ETFs are costs borne by the investor and are not included in expense ratios.

Editorial Disclaimer: Opinions expressed here are the author's alone, not those of any bank, credit card issuer, airlines, hotel chain, or other commercial entity and have not been reviewed, approved or otherwise endorsed by any of such entities.


This content is for educational purposes only and is not intended and should not be understood to constitute financial, investment, insurance or legal advice. All individuals are encouraged to seek advice from a qualified financial professional before making any financial, insurance or investment decisions.


Note: While the offers mentioned above are accurate at the time of publication, they're subject to change at any time and may have changed or may no longer be available.


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[![Soft vs. hard credit check: The difference, and why it matters](/cnn-underscored/money/images/uploads/2024/09/12022456/soft-vs-hard-credit-check-scaled-e1726122403764.jpg?width=438&fit=cover&format=webp)\
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Soft vs. hard credit check: The difference, and why it matters](https://www.cnn.com/cnn-underscored/money/soft-vs-hard-credit-check "Soft vs. hard credit check: The difference, and why it matters")

[![Debt snowball vs. debt avalanche: Which method is best to tackle your debt?](/cnn-underscored/money/images/uploads/2024/09/11025546/debt-snowball-vs-avalanche-scaled-e1726037815815.jpg?width=438&fit=cover&format=webp)\
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Debt snowball vs. debt avalanche: Which method is best to tackle your debt?](https://www.cnn.com/cnn-underscored/money/debt-snowball-vs-avalanche "Debt snowball vs. debt avalanche: Which method is best to tackle your debt?")

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