50%+ of US investors are invested in actively managed mutual funds with high expense ratios.

The average expense ratios for these mutual funds is 0.65% (65 basis points).

Index funds are passive mutual funds and have average expense ratios closer to 0.11%.

I wrote this post to briefly explain what index funds are and how they work.

This post compares index funds to mutual funds.

Expense Ratios 0.65% vs 0.11%

0.65% may not seem that much higher than 0.11% but for healthcare professionals we are talking about investing several hundred thousand dollars, if not millions, over our lifetime.

Expense ratios are charged on investments annually.

You can use the calculator on begin-to-invest to give you an idea of how much money you’d be missing out on by investing in a mutual fund versus an index fund.

Of course, your mutual fund might outperform the index fund which could more than make up for the expense ratio difference.

Example: If I start out with $100k and invest $50k for the next 30 years then the portfolio with an expense ratio of 0.11% will be ahead of the portfolio with a 0.65% expense ratio by as much as $427,000. Yes, you read that right. And yes, the math is right.

Calculating Overall Expense Ratio

What’s the average expense ratio of your portfolio?

Let’s say you have 3 funds: VTIAX, VTSAX, VBTLX.

They have the following expense ratios: 0.11%, 0.04%, 0.05%.

Depending on how much money you hold in each specific fund, you add up all the weighted expense ratios and you’d come up with the overall expense ratio.

Example: If your investment breaks down as I have laid out below then you’ll have a total of $100,000 invested:

• $20,000 in VTIAX (20% of portfolio) (ER=0.11%)
• $40,000 in VTSAX (40% of portfolio) (ER=0.04%)
• $40,000 in VBTLX (40% of portfolio) (ER=0.05%)

The weighted expense ratio then becomes the following based on how much you have invested in each fund:

• VTIAX (Weighted ER=0.022%) (=20%*0.11%)
• VTSAX (Weighted ER=0.016%)
• VBTLX (Weighted ER=0.02%)

Adding the above up we would get an overall expense ratio for the entire portfolio of 0.058%.

Are Expense Ratios Avoidable?

You can avoid expense ratios by investing in individual stocks and bonds. You only pay a single brokerage fee to buy the fund and one to sell it. And you’d pay taxes on any gains from the sale.

What’s The Ideal Expense Ratio?

There is no perfect answer to this. Except to say that you should only pay a higher expense ratio for a fund if you know for fairly certain that the particular fund will earn you a higher return.

The second point I’ll make is that if the majority of investors are in the 0.68% expense ratio range and you can have your portfolio at far less than that then you’ll have more wealth which means more buying power.

Do Higher Expense Ratios Mean A Higher Return?

Actually, studies have shown that the higher the expense ratios, the lower your investment returns. Think about that for a minute because that’s sort of shocking.

The only reason you would be willing to pay higher expense ratios is in hopes of higher investment returns.