ETFs, like mutual funds, pool investor money so that a professional portfolio manager can invest those funds in a particular market index or with a specific strategy. These portfolio managers must be paid for their services, and other costs must be covered including overhead, marketing, and trading fees. All of these fees are bundled together into the fund's expense ratio. (See also: Pay Attention to Your Fund's Expense Ratio.)

Key Takeaways

  • ETFs are increasingly popular as they provide the diversification and professional management of a mutual fund, but at lower cost.
  • Even with low costs, ETFs will charge fees for management, overhead, marketing, and trading (among other things) which are bundled into its expense ratio.
  • The gross expense ratio is the is the total percentage of a mutual fund's assets that are devoted to running the fund, while the net expense ratio includes trading costs and any reimbursements and waivers.

Expense Ratios

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

When evaluating the cost to own an ETF, you will often see two figures: a gross and a net expense ratio. These numbers are both important, but will contain different costs and convey different information about the fund's relative costliness.

Many investors find it difficult to understand the difference between gross expense ratio and net expense ratio. Here's how they differ.

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 (sometimes known as the total expense ratio) comes out of the share price after waivers and reimbursements. In some cases, a fund may have agreements in place for waiving, reimbursing or recouping some of the fund’s fees. This is often the case for new funds. An investment company and its fund managers may agree to waive certain fees following the launch of a new fund to keep the expense ratio lower for investors. The total expense ratio represents the fees charged to the fund after any waivers, reimbursements, and recoupments have been made. These fee reductions are typically for a specified time-frame after which the fund may incur all full costs.

Instead of what shareholders would have paid, the net expense ratio an actual payment as a percentage of assets under management. The next expense ratio will also typically include trading costs such as brokerage commissions, exchange fees, and clearing costs.

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. (See also: When Is an Expense Ratio Considered High and When Is it Considered Low?)

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.