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When talking about robo advisors sometimes the different fees and costs are not very clear.
One word that comes up a lot is “Fund Management Expense Ratio”.
Although this is a fee that is not directly related to the use of robo advisors, it is important to understand what exactly this is before starting to invest with a robo advisor.
Let’s first look at what an expense ratio actually is and then see how it relates to robo advisors.
What is a an expense ratio?
An expense ratio is the amount that an investment company charges investors to manage their portfolio, ETF or mutual fund.
This includes all of the management fees and operating costs of the fund. Things such as as rent, employee’s wages, administration expenses, the portfolio manager and other day-to-day operations of the fund come to mind.
What is Considered a High Expense Ratio?
This really depends what kind of investment we are talking about.
Typically ETFs have a very low expense ratio, the Vanguard ETF for index funds for example, has an expense ratio of only 0.05% of the total amount you invest. (Say you invest $10,000, you’ll only pay a mere $5 to the fund manager per year.)
Then you have index funds where the typical ratio is at about 0.2%. For actively managed portfolios on the other hand, a reasonable expense ratio is anywhere between 0.5% to 0.8%. An expense ratio greater than 1.5% is considered very high.
What does that mean for a robo advisor?
Most robo-advisors have a management fee. This fee is usually anywhere between 0.00% and 0.50%. The fee usually rises with the amount of human involvement within the service.
The fund’s management expense ratio, however is not included. It is a fee that will be paid for the ETF or mutual fund regardless of if you are investing with a robo advisor or not.
Don’t Fall For High Fund Management Expense Ratios
Luckily most robo-advisors build your portfolio with low-fee exchange-traded funds (ETFs) or mutual funds, so the fund’s management expense ratio will be on the lower end.
How does this fee affect my performance?
Of course, what any investor is most worried about is the actual performance of their portfolio.
So it is important to understand that this fee has no correlation with the performance of the fund whatsoever –
You will pay the expense ratio no matter what
There are also those ETFS and mutual funds that charge higher fees. However that doesn’t necessarily mean you will make less money off of it. Obviously you need to check their performance to see if the trade off between fee and performance makes sense.
In general, active fund managers, those that buy and sell securities instead of investing in an index, charge higher management fees.
So by all means, you can go for a fund with a higher than average management expense ratio, if they’ve significantly outperformed their benchmark. However keep in mind, even if a fund outperforms its others for many years, research has shown that this doesn’t continue indefinitely. The day that a fund can’t outperform their competitors anymore can come at any moment, yet the fee will still be the same.
It is getting more and more difficult to outperform the indexes. That is why robo advisors will stick with ETFs as the main strategy of their portfolio. They don’t try to outperform the market, they will usually go with the lower risk approach and also stay away from the higher fee funds.
Don’t get yourself scammed!
Of course fund managers will always try to get the most out of their clients. However as investors become more sophisticated, investors are becoming less inclined to pay the higher fees and nowadays the smart investors less willing to pay those high fees. Now that you know how high the fees usually are, you should be able to avoid falling for a fund that has fees that dont justify their performance.
With the help of cheap brokers such as Vanguard, Fidelity and others, you can just manage it on your own or use a robo advisor to automate the maintenance of your porfolio.
Be aware of high fees! Even the typically low fee ETFs and mutul fund fees can add up over time.
If you are a DIY investor, there are many brokerage firms that offer a great variety of low fee ETFs you can buy without paying a commission.
If you want to go for a robo advisor, luckily, most won’t charge you a commission fee for buying the ETFs in your account, but some do, so that is also something that needs to be researched before making your decision of opting for a specific robo advisor.
Michael is a senior writer at The Robo Investor. He earned his master’s at the Craig Newmark School of Journalism at CUNY, and is currently taking CFP courses at the University of Scranton. He has been an avid finance enthusiast ever since he started investing at the age of 23. Meet the Team