What Is an Expense Ratio?

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What Is an Expense Ratio?

Let me explain what an expense ratio really is. It's the measure of how much you'll pay each year to own a fund, shown as a percentage of your investment. You calculate it by dividing the fund's operating expenses by its net assets. For instance, if you've got $5,000 in an ETF with a 0.04% expense ratio, you're looking at paying just $2 annually.

Key Takeaways

You should know that the expense ratio gauges mutual fund operating costs against assets. As an investor, pay close attention to it to decide if a fund fits after accounting for fees. These ratios can appear as gross, net, or after-reimbursement versions. Expect passive index funds to have lower ratios than actively managed ones or those in less liquid assets. Overall, expense ratios are dropping as funds compete harder for your money.

Calculating the Expense Ratio

You rarely need to calculate a fund's expense ratio yourself because it's required in the prospectus and usually on the fund's website. But if you must, here's the formula: ER equals total fund costs divided by total fund assets. Total fund costs include management, transfer agent, accounting, custodian, trustee, auditing, legal, interest, miscellaneous, and other operating fees—but not loads or commissions. Total fund assets are the fund's net assets, which you can find in financial statements or on the webpage.

Fast Fact

Generally, a lower expense ratio is better for most investors like you.

Components of an Expense Ratio

Most expenses in a fund are variable, but they're fixed as a percentage because of how the ratio works. For example, a 0.5% fee always takes 0.5% of assets, no matter the variation. Besides management fees, some funds include a 12b-1 fee for advertising and promotion, capped at 1% by FINRA rules—0.75% for distribution and 0.25% for shareholder servicing. Remember, trading activity like buying and selling securities isn't in the expense ratio. Costs like loads, contingent deferred sales charges, and redemption fees are paid directly by you if they apply, not included in operating expenses.

Important Note

You often focus on total net expenses in the ratio, but sometimes investors prefer comparing gross versus net expenses.

Expense Ratios of Passive vs. Active Funds

Expense ratios differ between passive and active funds based on their structure and management. Many ETFs and mutual funds track indexes passively, keeping fees very low. Actively managed ones have higher ratios due to their strategies. Some use asset-weighted approaches, holding more from certain issuers or sectors, which can raise ratios compared to non-weighted funds. Take the Vanguard S&P 500 ETF (VOO)—it's passive with a rock-bottom 0.03% ratio, no asset-weighting. But the Vanguard Consumer Staples ETF (VDC) does weight sectors differently and sits at 0.10%. The Fidelity Contrafund (FCNTX), an active fund, has a 0.39% ratio and weights heavily toward communication services over its benchmark.

Fast Fact

In general, ETFs have lower expense ratios than similar mutual funds.

What Does Expense Ratio Mean?

The expense ratio is simply the portion of a fund's assets going to administrative and operating expenses. It reduces the fund's assets, which means lower returns for you as an investor.

Why Is Expense Ratio Important?

This ratio matters because it tells you exactly how much you're paying to invest in a fund and how much it cuts into your returns. A lower ratio means you keep more of your capital's gains.

How Is Expense Ratio Calculated?

You calculate it by dividing the fund's net expenses by its net assets.

The Bottom Line

Expense ratios come out of mutual fund and ETF returns to cover operations and management. The ratio you face depends on the fund's strategy and trading activity. They've been falling as competition grows. Active funds and those in less liquid classes usually have higher ratios, while passive index funds keep them the lowest.

What Is an Expense Ratio?

Highlights