Low cost index funds and ETF’s are a rage and the concept was pioneered by John Bogle. Before that mutual funds had heavy expense ratios that they charged to the customer.
What is an expense ratio – The expense ratio is an indicator of the expenses that an investment company incurs for the management of the fund. The way it is calculated is that annually the fund takes stock of its operating expenses and these are then divided by the assets under management. The way it is charged to the investors is that this expense is taken straight out the assets under management essentially translating into a lower return for the investors.
Why it is required – To run the fund , the fund company requires to pay the salaries of the fund managers, legal bills, costs of running the fund, record keeping expenses, auditing expenses etc. These several things are required to be paid by the fund to run a mutual fund. Remember that running a mutual fund will mean fund mangers, research analysts on the fund. These analysts look at companies to invest and believe me that these do not come cheap. That is why it ETF’s generally have lower expense ratios as the running of these low cost options do not require a team of analysts as such. These ETF’s just mirror the index that they are following and do not have team of analysts pouring of research reports to pick a stock. ETF’ and low cost index fund can hence easily charge low expense ratios.
Low cost vs high expense ratios examples
Here are some comparisons of the low cost options versus the high cost mutual funds.
Typically all the actively managed mutual funds will be having higher expense ratios and they will have to charge that to customers to pay for the experts who are trying to beat the index.
Low cost ETF and index funds
Vanguard 500 – It has an expense ratio of 0.12%. This is low however it is still higher than a new S&P 500 ETF that Vanguard launched and that has an expense ratio of .06%.
Spartan 500 index fund from Fidelity – This Spartan fund has an expense ratio of 0.05% beginning Dec 2012. This is for the Advantage series where the minimum amount that is required to be invested is $10000. However that is the lowest expense. In fact Schwab has one where it is charging 0.04% expense ratio.
High Expense ratio
Now look at the Fidelity Advisor Biotechnology Fund and it has an expense ratio of 1.6%.
Another that has expense ratio high enough is Fidelity Select Construction and Housing Portfolio. This has an expense ratio of 0.96%