Managing a mutual fund or an ETF involves a variety of expenses, such as management costs, marketing expenses, accounting expenses, trading expenses, etc. These expenses are disclosed in the form of an ‘expense ratio’, obtained by dividing the total amount of annual expenses by the funds total capital.
Are expense ratios important?
The answer is NO, despite of what you may have read in much of the popular investment literature. In reality, the expense ratio of a fund is completely irrelevant, for the following reason.
The total return
What is important is the total return of the fund. The total return is the amount of earnings investors derived from a fund during a specified period of time, such as the last year, the last five years, etc. The total return includes the increase in the fund’s share price and the dividends (or distributions) the fund paid out during that period.
The total return is the net amount of investor earnings; it is calculated after expenses have been deducted. A fund with a high total return is better than a fund with a low total return, even if it has a higher expense ratio. What matters is your earnings (the total return), not the cost of generating these earnings (the expense ratio). The emphasis on the expense ratio is misleading; it originated from some misleading advertisements by a certain mutual fund company.
Let me repeat that again: choose your mutual funds and ETFs based on their total return, not based on their expense ratios. The only thing that matters is the net amount of your profit (the total return), not how much it costs to generate it. Mutual funds with the lowest expense ratio don’t always have the highest total returns, and vice versa, funds with high expense ratios don’t always produce the lowest returns. Expenses are not important, since they are deducted, when the total return is calculated. Simply ignore the entire issue of expense ratios. Choose your funds based on their total returns.
It is best to buy your mutual funds or ETFs from a brokerage firm, and not directly from the issuers of the funds. It’s better to use a brokerage firm because it offers a large variety of mutual funds and ETFs to choose from, so you can easily switch from one fund to another, as market conditions change.
Brokerage firms may charge a ‘brokerage fee’ for buying and selling mutual funds and ETFs. The brokerage fees vary from one broker to another, as well as from one mutual fund to another, so let’s look at the situation in more detail.
No fee mutual funds
Most brokerage firms include in their inventory a selection of mutual funds for which they charge no brokerage fees: there is no fee for buying or selling these mutual funds at this brokerage firm.
Mutual funds with trading fees
For these mutual funds, brokerage firms charge a trading (or brokerage) fee. The trading fee varies from one brokerage firm to another, but it is usually in the range of $35-$80 per transaction. You pay the trading fee once when you buy shares of the mutual fund, and pay the same fee again when you sell shares of the mutual fund.
ETF trading fees
ETF trading fees are similar to the trading fees of individual stocks. These are most often in the range of $7-$15 per transaction, depending on the brokerage firm and your type of account.