An expense ratio is the amount companies charge investors to manage a mutual fund or exchange-traded fund (ETF). The expense 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 for all the assets within the fund.
High and Low Ratios
A number of factors determine whether an expense ratio is relatively high or low. However, a good, low expense ratio is generally considered to be around 0.5 to 0.75% for an actively managed portfolio while an expense ratio greater than 1.5% is considered high.
The expense ratio for mutual funds is typically higher than expense ratios for ETFs. ETFs are passively managed and benchmarked to an index such as the S&P 500. A mutual fund, on the other hand, is actively managed whereby securities are bought and sold.
Mutual funds tend to carry higher expense ratios than ETFs because they require more human management.
The average expense ratio for actively managed mutual funds is between 0.5% and 1.0% and typically goes no higher than 2.5%, although some fund ratios have gone higher. For passive index funds, the typical ratio is approximately 0.2%.
Expenses can vary significantly between the different 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 number of assets usually has a higher expense ratio due to its limited fund base for covering costs.
International funds can have high operational expenses if they require staffing in several countries. With an average expense ratio of 1.25%, large-cap funds are typically less expensive than small-cap funds, which average 1.4%.
Fund expenses can make a significant difference in investor profitability. If a fund realizes an overall annual return of 5% but charges expenses that total 2%, then 40% of the fund's return is offset by fees. Therefore, investors should compare expenses when researching funds. Investors can find a fund's expenses in a fund prospectus or listed on 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 specified financial market index. This type of investing is considered passive, and portfolio managers buy and hold a representative sample of the securities in their target indexes.
Thus, index funds tend to have below-average expense ratios. In contrast, under active management, managers may increase or reduce exposure to sectors or securities, and they may undertake significant research on stocks or bonds. This additional work means that investments under active management are more costly.
Index mutual funds also tend to have lower expense ratios because they focus on large-cap blend funds that target US large-cap indexes, such as the S&P 500. Actively managed portfolios, on the other hand, include stock with varying market capitalization. Stock is often international and/or from specialized sectors, so management of 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% or thereabouts.