An expense ratio reveals the amount that an investment company charges investors to manage an investment portfolio, a mutual fund, or an exchange-traded fund (ETF). The ratio represents all of the management fees and operating costs of the fund.

The expense ratio is calculated by dividing a mutual fund’s operating expenses by the average total dollar value of all the assets in the fund. Expense ratios are listed on the prospectus of every fund and on many financial websites.

Key Takeaways

  • The expense ratio is the annual cost paid to fund managers by holders of mutual funds or ETFs.
  • Competition has led expense ratios to fall dramatically over the past several years.
  • A reasonable expense ratio for an actively managed portfolio is about 0.5% to 0.75%, while an expense ratio greater than 1.5% is typically considered high these days.
  • For passive or index funds, the typical ratio is about 0.2% but can be as low as 0.02% or less in some cases.

High and Low Ratios

A number of factors determine whether an expense ratio is considered high or low. A good expense ratio, from the investor's viewpoint, is around 0.5% to 0.75% for an actively managed portfolio. An expense ratio greater than 1.5% is considered high.

The expense ratio for mutual funds is typically higher than expense ratios for ETFs. This is because ETFs are passively managed. The assets held in them are selected to mirror an index such as the S&P 500, and changes to the selection rarely need to be made. A mutual fund, on the other hand, is actively managed. The assets in them are constantly monitored and changed to maximize the performance of the fund.

Mutual funds tend to carry higher expense ratios than ETFs because they require more hands-on management.

The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%. They rarely exceed 2.5%. For passive index funds, the typical ratio is about 0.2%.

Factors Affecting Expense Ratios

Expenses can vary significantly between types of funds. The category of investments, the strategy for investing, and the size of the fund can all affect the expense ratio. A fund with a smaller amount of assets usually has a higher expense ratio due to its limited fund base for covering costs.

International funds can have high operational expenses because they may require staffing in several countries.

Large-cap funds, with an average expense ratio of 1.25%, are typically less expensive than small-cap funds, which average 1.4%.

The Impact on Investor Profit

Fund expenses can make a significant difference in an investor's profit. If a fund realizes an overall annual return of 5% but charges expenses that total 2%, then 40% of the fund's return is eaten by fees.

That's why investors should always compare expenses when researching funds. A fund's expenses will be listed in its prospectus and on the company's website, and can be found on many financial websites.

How Index Funds Paved the Way for Lower Expenses

As index funds have become more popular, they have encouraged lower expense ratios. Index funds replicate the return on a specific market index. This type of investing is considered passive. Their portfolio managers buy and hold a representative sample of the securities in the target indexes, and then leave them alone unless the index itself changes. Thus, index funds tend to have below-average expense ratios.

What Active Management Means

The managers of funds that are actively managed may increase or reduce the fund's exposure to individual stocks or entire sectors. They undertake considerable research and analysis when considering stocks and bonds. This additional work means that investments under active management are more costly.

Actively managed portfolios tend to be wider-ranging. Their managers look at stocks with varying market capitalizations as well as international companies and specialized sectors. Managing the assets requires more expertise.

As a general rule, mutual funds that invest in large companies should have an expense ratio of no more than 1%, while a fund that focuses on small companies or international stocks should have an expense ratio lower than 1.25%.

The Bottom Line

Like most things, you often get what you pay for. In the world of investing, however, there is ample evidence that low-cost passive funds that employ an indexing strategy often outperform active management, especially after accounting for fees and taxes. For active funds, expense ratios that are high need to be justified by extraordinary returns, or must confer some other benefit to investors since competition has made management fees decline so sharply over the past decade.