Key Takeaways
- Expense ratios measure a fund’s operating costs as a percentage of assets.
- Lower expense ratios are generally better for investors.
- Passive funds typically have lower expense ratios than active funds.
- Expense ratios exclude trading costs but include management and 12b-1 fees.
- Investors can find expense ratios in fund prospectuses and websites.
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Investopedia / Theresa Chiechi
What Is an Expense Ratio?
An expense ratio measures how much you’ll pay over the course of a year to own a fund, expressed as a percentage of your investments. An expense ratio is calculated by dividing a fund’s operating expenses by its net assets. For example, if you have $5,000 invested in an ETF with an expense ratio of .04%, you’ll pay the fund $2 annually.
How to Calculate an Expense Ratio
It’s very rare to need to calculate a fund’s expense ratio because a fund is required to furnish 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 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).
Fast Fact
Generally, the lower the expense ratio, the better it is for most investors.
Expense Ratio Components Explained
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 its 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.
Important
The expense ratio is often concerned with total net expenses, but investors sometimes want to use gross versus net expenses.
Comparing Expense Ratios: 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 because of 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 expense ratio: 0.10%. 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 0.39% ($39 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 the amount of a fund’s assets 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 funds 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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