The expense ratio calculator is a tool for you to understand the costs the ETF or mutual fund will charge you. Find out below what the expense ratio means for you, what the formula for the cost calculation is, and a real-life example with an S&P 500 ETF.
What is the expense ratio?
The expense ratio is a measure of cost for ETFs or mutual funds. It indicates how much fees the fund will deduct from your investment capital annually. These yearly fees are operational expenses such as management fees and administrative costs. Check in the prospectus of the fund what the fees exactly include. You will find the expense ratio of the fund in the prospectus as well.
The ratio is expressed in a percentage, 0-100%, of the fund’s average net asset value (NAV). When the fund has an expense ratio of 1%, the investor will be charged 1% of his/her investment in the fund on an annual basis.
What is a good expense ratio?
In general, a lower expense ratio is favorable for investors. Because this results in a higher net return for the investor. Compounding teaches us that the more capital you have, the faster it can grow in absolute terms.
A good expense ratio varies depending on the type of fund. For example for passively managed funds, like ETFs, the ratio is lower compared to actively managed funds. An expense ratio below 0.5% for an ETF is considered good. While for actively managed funds this is always higher.
When you look for a good fund, compare the ratios of the different funds with the expense ratio calculator. This gives you a good idea of what is considered good within the same type of funds.
How does the expense ratio calculator work?
The expense ratio calculator is a tool for calculating the fees the fund will charge you during your investment period. In other words, it calculates the effect the expense ratio has on your investment capital over the investment period.
The calculator takes into account your initial investment, yearly extra investment, expected return, expense ratio, and the duration of your investment. It calculates the future value of your investment and also the total costs you have to pay the fund over the investment period.
How to calculate the effect of the expense ratio?
The calculation has two parts. The initial investment future value (FVI) and the periodic investment future value (FVPI) result in future value of the total investment (FVTI).
FVTI = FVI + FVPI
We define now the variables to calculate both the FVI and FVPI:
- I_0 = initial investment capital allocated to fund
- I_{period} = yearly additional investment
- n = number of years you invest in the fund
- r_{exp} = the yearly expected return of the fund
- ER = expense ratio
The formula for initial investment future value (FVI) is:
FVI = I_0 * (1 + r_{eff})^n
Where:
r_{eff} = r_{exp} \>- \>ER
And for the periodic investment future value:
FVPI = \dfrac{I_{period} * ((1 + r_{eff})^n \>-\> 1}{r_{eff}}
How to calculate the costs of the expense ratio?
We need the previous formulas of calculating the future value of the total investment. First we calculate the FVTI without the expense ratio. And second, the precise formula from above is used. The cost of the ETF is the subtraction of both.
ETF_{cost} = FVTI_{without ER} \>-\> FVTI
Where FVTI_{withoutER}:
r_{eff} = r_{exp}
Expense ratio example with Vanguard S&P500 VOO
In this example, we want to invest $10000 and every year we contribute an extra $1000 to the fund. We do this for 10 years in a row. The expense ratio is 0.03%. Let’s use for the expected return the average of the S&P 500 over the last 10 years: 12.74%.
When we use the expense ratio calculator, we get a future value of the total investment of $51,246.96. The total cost of the fund over 10 years is $114.60.
The expense ratio may not be enough to choose between funds. Here you find a detailed analysis between to prominent ETF’s: VOO & VTI?
Frequently Asked Questions (FAQ)
ETF is an abbreviation for Exchange Traded Fund, which is a security with pooled investments. This type of fund is bought and sold on the stock exchange like any other stock. Which makes it easily accessible for retail investors. An ETF typically tracks an index such as the S&P 500. Also, industries, sectors, commodities, bonds, and other assets are tracked.
A mutual fund is a company that pools capital from many investors together. The fund can invest in stocks, bonds, and other assets, just like an ETF. The main difference is that this fund is not bought and sold on the stock market, but directly bought from the company or through a broker for the fund.
Investing in funds is a passive investing strategy. Following this strategy is easy and preferred by many investors. It cost less time to invest in an S&P 500 ETF compared to stock picking yourself. Invest in funds by following the first 7 easy-to-follow steps out of 10 steps of becoming an investor.
