What Is an Expense Ratio? Definition

Investing
Updated: 17th Sep 2021
Written by Andrew
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Investing
September 17, 2021
Written by Andrew

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The name of the investing game is generating gains while paying the least amount in taxes and fees to do so.

As such, those interested in funds – such as mutual funds and exchange-traded funds (ETFs) – will want to pay attention to an investment’s expense ratio.

This little fee may not seem like much, but the costs can add up quickly in a portfolio worth thousands of dollars.

>> More: How to Start Investing

What is an Expense Ratio?

An expense ratio, sometimes called a management expense ratio (MER) measures the cost of operating a fund compared to its assets under management (AUM).

Or, from the investor’s viewpoint, it reflects how much you’ll pay per year to own a particular fund.

For instance, if a mutual fund carries an expense ratio of 1%, you’d pay $10 per year for every $1,000 that you invest. The money raised covers the fund’s operating costs, such as:

  • Management and custodial expenses
  • Marketing and advertising costs
  • Recordkeeping, account, and auditing
  • Legal fees

Bear in mind that most funds take the money out of your investment account directly.

While this saves you the trouble of remembering to pay your bill on time, it’s also easy to miss the money leaving your possession – making tracking your expense ratios that much more important.

Understanding the Expense Ratio

Various funds, such as mutual funds, index funds, and ETFs, charge expense ratios. And because every fund sets its ratio based on the costs of managing that particular fund, some are higher than others.

For instance, mutual funds and actively traded funds tend to charge more to cover the costs of hiring a hands-on professional to research and execute trades.

On the other hand, most passively managed funds track a particular index, which lowers overhead costs.

Additionally, expense ratios may fluctuate due to the variable nature of some costs, such as accounting, registration, and legal fees.

But other expenditures are more static. And when it comes to marketing expenses, funds are restricted to 1% of the average value of their assets.

That said, for the most part, costs within set funds tend to remain stable. For instance, funds with low expenses will continue to have low expenses, and vice versa.

And for most, the bulk portion of the proceeds goes toward paying the fund’s advisor or investment manager.

>> More: How to Buy Stocks

What Does the Expense Ratio Not Cover?

Note that expense ratios don’t account for fees such as commissions, trading fees, and of course, the taxes you pay on dividend income and capital gains. Some mutual funds also charge up-front fees, or loads, in addition to their expense ratios.

An Example of the Expense Ratio

For a real-life example, take the SPDR S&P 500 Trust ETF. This is one of the most popular funds tracking the S&P 500 Index, comprised of 500 large- and mid-cap U.S. stocks.

This well-diversified fund charges a low expense ratio of 0.095%, which comes out to 95 cents for every $1,000 you invest.

The Difference Between the Expense Ratio and Management Fees

Funds charge management fees, sometimes called maintenance fees. The management fee encompasses all direct expenses incurred as part of the management process, including hiring and retaining investment advisors.

This typically comprises the bulk of such fees, often ranging between 0.5% and 1% of a fund’s assets under management (AUM).

Note that the cost of buying and selling securities for the fund is not included in the management fee. Instead, you can find these listed as “trading expense ratios” in the prospectus. And together, operating, trading and management fees make up the total expense ratio.

How to Calculate Expense Ratios

You can determine a fund’s expense ratio by dividing a fund’s total operating costs by the average dollar value of its net assets. However, funds are required to publish their expense ratios where investors can find them.

If you want to calculate how an expense ratio impacts you, simply multiply the ratio by the dollar amount of your annual investment.

For instance, if you buy shares in a mutual fund with an expense ratio of 0.72%, you’ll pay $7.20 for every $1,000 you invest. For a portfolio worth $50,000, that comes out to $360 in fees annually.

How to Find a Fund’s Expense Ratio

Investment funds are required by law to publish their expense ratio in their prospectus, which you can find on the fund company’s website.

Your online broker, retirement plan provider, or financial advisor can also furnish your investment’s expense ratio information.

And many financial news websites and journals, such as Google Finance, MarketWatch, and The Wall Street Journal, also publish funds’ expense ratios.

Researching and Comparing Expense Ratios

When looking at a fund’s expense ratios, it’s crucial to ensure you’re comparing like funds. For instance, most active and mutual funds carry higher fees.

However, they also pay a fund and or portfolio manager to oversee trading activity and perform research. By contrast, most passive funds track an index.

That said, research shows that active funds don’t outperform their passive counterparts when analyzing long-term performance.

As such, you’ll want to ask yourself if the potential for greater short-term gains is worth the higher fees, especially if you’re investing on a long-term horizon.

Expense Ratio FAQs

What does expense ratio mean? 

A fund’s expense ratio is the amount that the fund will charge you to invest your money.

Is a high expense ratio good or bad? 

The higher the expense ratio, the more money you pay for every dollar you invest, which means less money for you. In other words, lower expense ratios would always be better in a vacuum that doesn’t account for the quality of a fund.

What is a good expense ratio? 

The cost of expense ratios has dropped over time with the rise of passive funds and lower technological costs. Today, an actively managed fund with an expense ratio over 1-1.5% is considered expensive, while 0.5-0.75% is more reasonable. For a passive fund, a “good” expense ratio can fall below just 0.2%.

What is an expense ratio for an ETF? 

ETFs are passively managed funds that cost less to operate than their actively managed counterparts. As such, their expense ratios tend to be relatively low – usually less than 0.5%, with some falling well below 0.2%.

Why is expense ratio important? 

Every dollar you pay in fees is another dollar you aren’t getting from your investments. And since the point of investing is generating returns, an expense ratio provides a quick way to analyze the cost of buying into a particular fund.

A high ratio can also point to a fund that’s too comfortable with keeping costs high at its investors’ expense. However, low isn’t always better – you want to make sure that you’re investing in quality funds.

Bottom Line: Expense Ratio Definition

If you’re looking to save on investment costs, analyzing a fund’s expense ratio is a great place to start.

Higher ratios mean that the fund takes more of your assets – regardless of whether it turns a profit.

And remember, the cost of an expense ratio only accounts for owning the fund, not purchasing, and redeeming your shares, which can also increase your costs.

Andrew
Andrew
Andrew is an editor-writer living and working in Southern California. While he’s previously focused on editing for financial publications, he’s now dabbling in the writing pool as well. Hobbies include listening to podcasts, and learning about all things financial. (Just don't ask him about logarithms.)