• Thu. May 23rd, 2024

Definition, Formula, Components, and Example

What Is an Expense Ratio?

The expense ratio is how much you pay a mutual fund or ETF per year, expressed as a percent of your investments. So, if you have $5,000 invested in an ETF with an expense ratio of .04%, you’ll pay the fund $2 annually.

An expense ratio is determined by dividing a fund’s operating expenses by its net assets. Operating expenses reduce the fund’s assets, thereby reducing the return to investors because the expense ratio is deducted from the fund’s gross return and paid to the fund manager.

Key Takeaways

  • The expense ratio is a measure of mutual fund operating costs relative to assets.
  • Investors pay attention to the expense ratio to determine if a fund is an appropriate investment for them after fees are considered.
  • Expense ratios may also be expressed as gross, net, and after-reimbursement expense ratios.
  • Passive index funds will have lower expense ratios than actively managed funds or those in less liquid asset classes.
  • In general, expense ratios have declined as competition for investor dollars has increased.

Investopedia / Theresa Chiechi


Calculating the Expense Ratio

It’s very rare to need to calculate a fund’s expense ratio, as it is required to state it in its prospectus. Additionally, because it is an important metric for investors, expense ratios are almost always found on a fund’s website. But if you need to calculate it, this is the formula:


ER = Total Fund Costs Total Fund Assets \beginaligned &\textER = \frac \textTotal Fund Costs \textTotal Fund Assets \\ \endaligned
ER=Total Fund AssetsTotal Fund Costs

Where:

  • Total Fund Costs: The total of all management, transfer agent, accounting, custodian, trustee, auditing, legal, interest, miscellaneous, and other relevant operating fees (does not include loads or commissions)
  • Total Fund Assets: The fund’s net assets

You’ll need to locate the fund’s operating expenses in its financial statements and net assets on its webpage (or financial statements).

Generally, the lower the expense ratio, the better it is for most investors.

Components of an Expense Ratio

Most expenses within a fund are variable; however, the variable expenses are fixed within the fund because of how it is calculated. For example, a fee consuming 0.5% of the fund’s assets will always consume 0.5% regardless of how it varies.

In addition to the management fees associated with a fund, some funds have an advertising and promotion expense referred to as a 12b-1 fee, which is included in operating expenses. Notably, 12b-1 fees within a fund cannot exceed 1% (0.75% allocated to distribution and 0.25% allocated to shareholder servicing) according to FINRA rules.

A fund’s trading activity—the buying and selling of portfolio securities—is not included in the calculation of the expense ratio. Costs not included in operating expenses are loads, contingent deferred sales charges (CDSC), and redemption fees, which, if applicable, are paid directly by fund investors.

The expense ratio is often concerned with total net expenses, but investors sometimes want to use gross vs. net expenses.

Expense Ratios of Passive vs. Active Funds

The expense ratios of passively managed funds and actively managed funds depend on how they are structured and managed:

  • Many ETFs and mutual funds are passively managed funds that track an index, which allows them to have very low fees.
  • There are several actively managed mutual funds and ETFs that have higher expense ratios due to their goals and strategies.
  • Many active and passive funds use asset-weighted strategies, which means they hold more assets from specific issuers or sectors than others based on a value comparison—leading to higher expense ratios than funds that don’t use asset-weighting.

The Vanguard S&P 500 ETF (VOO), a passively managed index fund that replicates the Standard & Poor’s (S&P) 500 Index, has one of the lowest expense ratios in the industry at 0.03% annually. This fund does not use asset-weighting, but the Vanguard Consumer Staples ETF (VDC) does—and it has a much higher 0.10% expense ratio. VDC mimics the MSCI US IMI Consumer Staples 25/50 index but weighs three sectors differently than the index.

The Fidelity Contrafund (FCNTX) is one of the largest actively managed funds in the marketplace, with an expense ratio of 0.86%, or $86 per $10,000 invested. This fund is much more highly weighted toward communication services than its benchmark, the S&P 500.

What Does Expense Ratio Mean?

The expense ratio is how much of a fund’s assets are used towards administrative and other operating expenses. Because an expense ratio reduces a fund’s assets, it reduces the returns investors receive.

Why Is Expense Ratio Important?

The expense ratio of a fund or ETF is important because it lets an investor know how much they pay to invest in a specific fund and how much their returns will be reduced. The lower the expense ratio the better because an investor receives higher returns on their invested capital.

How Is Expense Ratio Calculated?

The expense ratio is calculated by dividing a fund’s net expenses by its net assets.

The Bottom Line

Expense ratios are taken from mutual fund and ETF returns to help pay for operations and fund management. The expense ratio charged to investors will vary depending on the fund’s investment strategy and level of trading activity. In general, expense ratios have declined steadily as competition for investor dollars has heightened.

Actively managed funds and those in less liquid asset classes tend to have higher expense ratios, while passively managed index funds feature the lowest expense ratios.

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