What drives your fund costs up or down?
June 25, 2013
Unlike other mutual fund providers, Vanguard offers its funds "at cost." That means shareholders pay Vanguard only what it costs to manage a fund. Nothing more.
What is an expense ratio?
The costs of operating a fund—including investment advisory fees, administrative costs, and expenses related to providing shareholder services—are reflected in its "expense ratio."
Crunching the numbers
What do all these numbers mean to you? A hypothetical fund with a 1.0% expense ratio charges you $100 each year for every $10,000 you've invested in it. A fund with a 0.2% expense ratio charges you $20 each year. Over time, differences like that can really add up.
Typically, the expense ratios reported in a Vanguard fund prospectus and on vanguard.com are backward-looking: They represent the costs incurred by the fund during its previous fiscal year divided by average fund assets during that year. The expense ratio that results from this calculation appears in the updated prospectus that Vanguard files annually with the Securities and Exchange Commission.
Bringing down the cost of investing
Several studies have shown that funds with lower expense ratios, as a group, deliver better performance than higher-cost funds—because investors keep more of their returns.* We have a long history of adding value for shareholders by reducing the expense ratios on our funds. The average expense ratio on Vanguard funds offered for sale in the U.S. decreased from 0.89% in 1975 to 0.19% in 2012. (Source: Lipper and Vanguard.)
But does that mean that an increase in a fund's expense ratio is always bad news for investors? The answer depends on the reason for the increase.
Why do expense ratios change?
As with any ratio, the expense ratio can change based on changes to the numerator (costs), the denominator (average fund assets), or both.
Two common drivers of adjustments to a fund's expense ratio are changes in the value of fund assets and, for actively managed funds, the terms of the contract between Vanguard and third-party investment advisors.
When assets grow (whether from market appreciation or cash flow), a fund achieves economies of scale. Fixed costs spread over the larger asset base represent a smaller share of assets. Conversely, if fund assets decline—as they did during the bear market from late 2007 to March 2009—fixed costs represent a larger slice of fund assets, driving up the expense ratio.
For actively managed funds, most of Vanguard's contracts with external advisors include a base fee plus or minus a performance adjustment. If the advisor outperforms the designated benchmark index, the firm's fee increases. This is good news for shareholders as they directly benefit from the advisor's superior results. If the advisor underperforms, its fee declines.
The incentive-fee structure helps to ensure that the interests of the advisor and the fund's shareholders remain aligned, regardless of market conditions. Click View prospectus and reports on each fund's Overview page for more information on performance-based fees.
*For example, see Shopping for alpha: You get what you don't pay for.
- All investing is subject to risk, including possible loss of the money you invest.