An expense ratio is the cost investment 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.
A number of factors determine when an expense ratio is relatively high or low. But a good, low expense ratio is generally considered to be around 0.5-0.75% for an actively managed portfolio, while an expense ratio greater than 1.5% is considered on the high side.
The expense ratio for mutual funds is typically higher than expense ratios for ETFs. Exchange-traded funds are passively managed and benchmarked to an index. A mutual fund, on the other hand, is actively managed whereby securities are bought and sold. As a result, mutual funds tend to carry higher expense ratios than ETFs.
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 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, it's very important for investors to compare expenses when researching funds. Investors can find a fund's expenses in a fund prospectus or listed on financial websites.
As a rule of thumb, look for mutual funds that invest in large companies to 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.