The expense ratio is the annual fee that mutual funds and exchange-traded funds (ETFs) charge investors, to cover operating costs. The fee is deducted from your investment, reducing your returns each year — which is one reason why expense ratios have been shrinking.
Typically, investors may look for funds that offer lower expense ratios, as high expense ratios can take a substantial bite out of long-term returns, affecting investors’ financial plans.
Here’s a look at how expense ratios are calculated, what they encompass, and other factors worth considering when choosing a mutual fund or ETF to invest in.
How Expense Ratios Are Calculated
Though individual investors typically won’t find themselves in a situation where they need to calculate an expense ratio, it’s helpful to know how it’s done. To calculate expense ratios, funds use the following equation:
Expense Ratio = Total Fund Costs/Total Fund Assets Under Management
For example, if a fund holds $500 million in assets under management, and it costs $5 million to maintain the fund each year, the expense ratio would be:
$5 million/$500 million = 0.01
Expressed as a percentage, this translates into an expense ratio of 1%, meaning you would pay $10 for every $1,000 you have invested in this fund.
As you research funds you may come across two terms: gross expense ratio and net expense ratio. Both have to do with the waivers and reimbursements funds may use to attract new investors.
• The gross expense ratio is the figure investors are charged without accounting for fee waivers or reimbursements.
• The net expense ratio takes waivers and reimbursements into account, so it should be a lower amount.
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How Expense Ratios Are Charged
A fund’s expense ratio is expressed as a percentage of an individual’s investment in a fund. For example, if a fund has an expense ratio of 0.60%, an investor will pay $6.00 for every $1,000 they have invested in the fund.
The cost of an expense ratio is automatically deducted from an investor’s returns. In fact, when an investor looks at the daily net asset value of an ETF or a mutual fund, the expense ratio is already baked into the number that they see.
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The Components of an Expense Ratio
The fees that make up the operating costs of a mutual fund or ETF can vary. Generally speaking, the investment fees included in an expense ratio will include the following:
Management Fees
The management fee is the amount paid to the person/s managing the money in the investment fund — they make decisions about which investments to buy and sell and when to execute trades. Management fees can vary depending on how much activity is required of these managers to maintain the fund.
Custodial Fees
Custodial fees cover the cost of safekeeping services, the process by which a fund or other service holds securities on an investor’s behalf, guarding the securities from being lost or stolen.
Marketing Fees
Also known as 12b-1 fees, marketing fees are used to pay for the advertising of the fund, some shareholder services, and even employee bonuses on occasion. FINRA caps these fees at 1% of your assets in the fund.
Other Investment Fees
Investors may be forced to pay other investment fees when they buy and sell mutual funds and ETFs, including commissions on trades to a broker. The cost of buying and selling securities inside the fund is not included as part of the expense ratio. Additional costs that are not considered operating expenses include loads, a fee mutual funds charge when investors purchase shares. Contingent deferred sales charges and redemption fees, which investors pay when they sell some mutual fund shares, are also paid separately from the expense ratio.
How to Research Expense Ratios
Luckily, you do not have to spend your time calculating expense ratios on your own. The Securities and Exchange Commission (SEC) requires that funds publish their expense ratios in a public document known as a prospectus. The prospectus reports information important to mutual fund and ETF investors, including investment objectives and who the fund managers are.
Online brokers often allow you to look up expense ratios for individual investment funds, and they may even offer tools that allow you to compare ratios across funds.
Average Expense Ratios
Expense ratios vary by fund depending on what investment strategy it’s using. Passively managed funds that frequently track an index, such as the S&P 500 index, and require little intervention from managers, tend to have lower expense ratios. ETFs are usually passively managed, as are some mutual funds. Other mutual funds may be actively managed, requiring a heavier touch from managers, which can jack up the expense ratio.
Expense ratios have been falling for decades, according to the most recent Morningstar Annual U.S. Fund Fee study, released in June 2022. “In 2021, the asset-weighted average expense ratio of U.S. open-end mutual funds and ETFs was 0.40%, compared with 0.87% in 2001,” the report states.” While that difference may seem slight, investors saved an estimated $6.9 billion in fund expenses in just one year.
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What’s a Good Expense Ratio?
When considering expense ratios across mutual funds and ETFs, it’s helpful to use average expense ratios as a benchmark to get an idea of whether a specific expense ratio is “good.”
Investors may want to target funds with expense ratios that are below average. The lower the expense ratio, the less expensive it is to invest in the fund, meaning more profits would go to the investor vs. the fund.
That said, some investors may prefer to invest in actively managed funds, which typically charge higher fees than passive or index funds.
Looking Beyond Expense Ratios
When comparing mutual funds and ETFs, an investor might choose to consider other factors in addition to expense ratios.
It can be a good idea to consider how a particular fund will fit in their overall financial plan. For example, individuals looking to build a diversified portfolio may want to target a fund that tracks a broad index like the Nasdaq or S&P 500. Or, investors with portfolios heavily weighted in domestic stocks may be on the hunt for funds that include more international stocks.
And it’s also a good idea to know the key differences between mutual funds and ETFs. ETFs, for example, are generally designed to be more tax efficient than mutual funds, which can also have a big impact on an investor’s ultimate return. ETFs are generally lower in cost than mutual funds as well.
The Takeaway
Expense ratios seem small, but they can have a big impact on investor returns. For example, if an individual invested $1,000 in an ETF with a 6% annual return and a 0.20% expense ratio, and continued making a $1,000 investment each year for the next 30 years, they would earn $81,756.91, and spend $3,044.76 on the fund’s expenses.
But expense ratios are only one of many factors to consider when choosing a mutual fund or ETF. Fundamentally your investment choices have to fit into your larger financial plan. But cost should always be a concern.
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