When a person invests money in a mutual fund or exchange-traded fund, the fund provider must charge fees to cover its costs. The expense ratio tells an investor how much a fund charges to offset its operating costs. It is essential that investors understand the expense ratio because this metric directly affects the amount of profit the investor will make.
Expense Ratio Definition
The expense ratio for a mutual fund or ETF is the sum of the fund’s annual operating expenses divided by the fund’s average assets for the year. For example. a fund with operating expenses of $4 million and average assets of $500 million has an expense ratio of 0.8 percent.
An individual investor can use the expense ratio to calculate an estimate of the fee he will be charged for operating expenses by multiplying his investment by the expense ratio. Suppose he has invested $10,000 and the fund’s expense ratio is 0.8 percent. Multiply $10,000 by 0.8 percent. The fee comes to $80.
Expense Ratio Components
The expense ratio of a fund represents the sum of a variety of costs. Some of these costs are expenses for fund management, the fund’s board of directors, fund distribution and custodial fees. Others include legal costs, accounting, investor advisory expenses and the cost of shareholder reports. The expense ratio does not include sales fees, commissions or loads. It also does not include brokerage fees or interest and dividends on borrowed securities.
The above describes a gross expense ratio. Funds may also report a net expense ratio. The net expense ratio differs from a gross expense ratio in that it includes interest and dividends paid on borrowed securities.
Typical Expense Ratios
The average expense ratio has ranged from 0.78 percent to 0.82 percent in recent years. Expense ratios vary depending on the type of fund. For example, actively managed funds tend to have higher expense ratios than index funds that seek to mirror the makeup and performance of an index such as the Standard and Poors 500. Investors should do some comparison shopping before investing. As a rule, a fund’s performance should be good enough to more than offset a higher-than-average expense ratio.