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When it comes to investing, you’ve likely heard the arguments for putting your hard-earned money into exchange-traded funds (ETFs) or mutual funds to diversify your portfolio or to allocate more of your portfolio toward conservative investments like bonds as you age. Before you begin the investing process and siphon away thousands of dollars for retirement or other future financial goals, there’s one term you should absolutely familiarize yourself with: expense ratios.
Expense ratios can eat away at your investment earnings, so it’s important to know what they are and how they work. Below, Select takes a look at what expense ratios are, why they’re important and how they can vary by fund type.
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Defining expense ratios
An expense ratio is essentially a fee that investors pay for the management of a fund — be it an index fund, mutual fund and/or ETF — which includes all administrative, marketing and management fees. Try and think of it this way:
Expense Ratios = the fund’s net operating expenses / the fund’s net assets
Expense ratios are typically represented as a percentage. An expense ratio of 0.2%, for example, means that for every $1,000 you invest in a fund, you’ll be paying $2 annually in operating expenses. These funds are taken out of your expenses over time, so you won’t be able to avoid paying them. Just as your returns are magnified because of compound interest, your expenses are as well, which is why there may be a big difference in earnings if you choose to invest in a fund with a high expense ratio.
Let’s take a look at this example: You invest $5,000 a year and receive a constant 7% annual rate of return on your investments. According to the chart below, your earnings would be at least $25,000 more if you invested in the fund with a 0.3% expense ratio versus the fund with a 0.6% expense ratio.
|Expense Ratio||Net fees||<…….