An expense ratio is what each investor pays into a fund on an annual basis in order to cover:

Many investors find it difficult to understand the difference between gross expense ratio and net expense ratio. Here's how they differ. (See also: Pay Attention to Your Fund's Expense Ratio.)

Gross Expense Ratio

Gross expense ratio is the percentage of assets used to manage a fund before any waivers and reimbursements. Therefore, the gross expense ratio is what shareholders would have paid without those waivers and reimbursements. The gross expense ratio only impacts the fund, not the current shareholders.

If an exchange-traded fund has a 2% gross expense ratio and a 1% net expense ratio, it indicates that 1% of the fund’s assets are being used to waive fees, reimburse expenses and to offer rebates. But is this sustainable? That’s something you need to determine based on your own research. That said, if you see a gross expense ratio above 4%, you should be wary.

Net Expense Ratio

The net expense ratio comes out of the share price after waivers and reimbursements. Instead of what shareholders would have paid, it’s an actual payment as a percentage of assets under management. (See also: When Is an Expense Ratio Considered High and When Is it Considered Low?)

Understanding Waivers, Reimbursements

Newer and smaller funds will usually have higher gross expense ratios because they cost more to run on a relative basis. However, smaller funds will use waivers and reimbursements in order to attract new investors. Think of it like a retailer running a promotion in order to get more customers into the store. Another good example is a new supermarket that comes to town and uses lower prices in an attempt to steal share from an existing brand. After several weeks, or perhaps two to three months, the supermarket will raise prices to improve its margins. Like the retailer or supermarket, that promotional period for an ETF might come to an end. 

If the gross expense ratio is higher than the net expense ratio, then as an investor, you’re betting that assets under management will grow enough to offset those expenses. If that’s not how the situation plays out due to poor performance, then waivers will be eliminated. The wider the spread between the gross expense ratio and net expense ratio, the more likely waivers will be eliminated. Also look for the waiver end date if available. In simpler terms, if the gross is higher than the net, it increases the odds that the fund’s expense ratio will move higher in the future. (See also: Comparing ETFs vs. Mutual Funds for Tax Efficiency.)

The good news is that if the fund can grow its assets under management, then the fund becomes less expensive to manage, which then lowers the expense ratio. As an investor, this would be beneficial because higher expense ratios eat into your profits and exacerbate your losses.

Other Important ETF Factors

When you read about expense ratios, it’s the net expense ratio that’s being referred to. You can find this information by going to Yahoo Finance, entering the ETF ticker and selecting Profile. From there, scroll down to the Fund Summary section. Below that is a Fund Operations summary. This is where you will find the net expense ratio. If that expense ratio is above 0.44%, then it’s above the average expense ratio found throughout the ETF universe. This doesn’t mean that ETF should be discarded from investment consideration, but it does mean you will have to do your homework. For instance, does another ETF that’s tracking the same thing offer a lower expense ratio? Also, you will notice Annual Holdings Turnover in the Fund Operations section. If that percentage is high, then it indicates active management and will usually mean a high expense ratio. Passive ETFs usually have a low turnover and a low expense ratio.

Expense ratios are important, but they’re not the only metric to look for when choosing an ETF. Also look at the average daily trading volume. If it’s above 1 million shares per day, then it’s liquid, which will allow you to buy and sell with ease. Anything above 100,000 shares traded per day can be OK, but check the bid-ask spread to make sure it’s tight. Otherwise, you can be hit with hidden costs. In order to avoid this, use limit orders opposed to market orders.

If you’re going to trade volatile leveraged and inverse ETFs, then you should strongly consider having a specific game plan for buying shares and an exit strategy. Otherwise, the daily rebalancing, high expense ratios and commission fees have the potential to lead to a significant hit.

The Bottom Line

As an investor, you don’t pay into the gross expense ratio on an ETF. But if you see a wide spread between the gross and the net, it could indicate higher expenses down the road because it’s more likely that waivers and reimbursements will be eliminated. Also be aware of other risks associated with ETFs, especially for those that are actively managed. (See also: Active vs. Passive ETF Investing.