Expense Ratio: Definition, Formula, Components, Example

Expense Ratio

Investopedia / Theresa Chiechi

What Is an Expense Ratio?

The expense ratio measures how much of a fund's assets are used for administrative and other operating expenses. For investors, the expense ratio is deducted from the fund's gross return and paid to the fund manager.

An expense ratio is determined by dividing a fund's operating expenses by the average dollar value of its assets under management (AUM). Operating expenses reduce the fund's assets, thereby reducing the return to investors.

Key Takeaways

  • The expense ratio is a measure of mutual fund operating costs relative to assets.
  • Investors pay attention to the expense ratio to determine if a fund is an appropriate investment for them after fees are considered.
  • Expense ratios may be stated as gross expense ratio, net expense ratio, and after-reimbursement expense ratio.
  • Passive index funds will have lower expense ratios than actively-managed funds or those in less liquid asset classes.
  • In general, funds' expense ratios have been declining over the past several years.

Management Expense Ratio

What the Expense Ratio Can Tell You

Operating expenses vary according to the fund or stock; however, the expenses within the fund remain relatively stable. For example, a fund with low expenses will generally continue to have low expenses. The largest component of operating expenses is the fee paid to a fund's investment manager or advisor.

Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees. Expenses that are charged by the fund are reflected in the fund's daily net asset value (NAV) and do not appear as a distinct charge to shareholders.

The Formula for Calculating the Expense Ratio Is:

ER = Total Fund Costs Total Fund Assets \begin{aligned} &\text{ER} = \frac{ \text{Total Fund Costs} }{ \text{Total Fund Assets} } \\ \end{aligned} ER=Total Fund AssetsTotal Fund Costs

What Is a Good Expense Ratio?

In general, the lower the expense ratio, the better it is for investors. Actively-managed funds will typically come with higher expense ratios, and the amount of expenses will also vary depending on the fund's strategy or asset class focus. Compare expense ratios of similar funds in order to determine what is good.

For example, for 2022, the average expense ratio for actively-managed equity funds was 0.68% and index funds just 0.06%.  A mutual fund expense ratio that is at or below its peer average is ideal. 

Components of an Expense Ratio

Most expenses within a fund are variable; however, the variable expenses are fixed within the fund. For example, a fee consuming 0.5% of the fund's assets will always consume 0.5% of the assets regardless of how it varies.

In addition to the management fees associated with a fund, some funds have an advertising and promotion expense referred to as a 12b-1 fee, which is included in operating expenses. Notably, 12b-1 fees within a fund cannot exceed 1% (0.75% allocated to distribution and 0.25% allocated to shareholder servicing) according to FINRA rules.

A fund's trading activity—the buying and selling of portfolio securities—is not included in the calculation of the expense ratio. Costs not included in operating expenses are loads, contingent deferred sales charges (CDSC), and redemption fees, which, if applicable, are paid directly by fund investors.

The expense ratio is most often concerned with total net expenses, but sometimes, people want to understand gross expenses versus net.

Passive Index Funds vs. Actively Managed Funds

The expense ratio of an index fund and an actively managed fund often differ significantly. Index funds, which are passively managed funds, typically carry very low expense ratios. The managers of these funds are generally replicating a given index. The associated management fees are thus lower due to the lack of active management, as with the funds they mirror.

Actively managed funds employ teams of research analysts examining companies as potential investments. Those additional costs are passed on to shareholders in the form of higher expense ratios.

The Vanguard S&P 500 ETF, an index fund that replicates the Standard & Poor's (S&P) 500 Index, has one of the lowest expense ratios in the industry at 0.03% annually. At this level, investors are charged just $3 per year for every $10,000 invested. The Fidelity Contrafund is one of the largest actively managed funds in the marketplace with an expense ratio of 0.86%, or $86 per $10,000.

Example of Expense Ratios

In general, passively managed funds, such as index funds, will have much lower expense ratios than actively managed funds.

Consider two hypothetical mutual funds, the Active Fund (AFX) and the Index Fund (IFX). AFX seeks to beat the market by identifying underpriced stocks based on extensive research and experience. IFX instead seeks to exactly replicate the Dow Jones Industrial Average and holds the 30 stocks in the index at their respective weightings.

The expense ratio for AFX is 1.5%, and the expense ratio for IFX is 0.05%

Last year, AFX had a gross return of 10% while the Dow Jones returned 9%.

But, after accounting for the expense ratios, investors in AFX received a net return of 8.50%, while IFX investors enjoyed a higher net return of 8.95%.

Expense Ratio vs. Management Fees

Mutual funds charge management fees to cover their operating costs, such as the cost of hiring and retaining investment advisors who manage funds' investment portfolios and any other management fees payable not included in the other expenses category. Management fees are commonly referred to as maintenance fees.

A mutual fund incurs many operating fees associated with running a fund other than the costs to buy and sell securities and paying the investment team to make the buy/sell decisions. These other operating fees include marketing, legal, auditing, customer service, office supplies, filing costs, and other administrative costs. 

While these fees are not directly involved with making the investment decisions, they are required to ensure the mutual fund is run correctly and within the Securities and Exchange Commission's requirements.

The management fee encompasses all direct expenses incurred in managing the investments such as hiring the portfolio manager and investment team. The cost of hiring managers is the largest component of management fees; it can range between 0.5% and 1% of the fund's assets under management, or AUM.

Even though this percentage seems small, the absolute amount is in millions of U.S. dollars for a mutual fund with $1 billion of AUM. Depending on the reputation of management, highly skilled investment advisors can command fees that push a fund's overall expense ratio quite high.

Notably, the cost of buying or selling any security for the fund is not included in the management fee. Rather, these are transaction costs and are expressed as the trading expense ratio in the prospectus. Together, the operating fees and management fees make up the expense ratio.

In general, exchange traded funds (ETFs) have lower expense ratios than comparable mutual funds.

What Does Expense Ratio Mean?

The expense ratio refers to how much of a fund's assets are used towards administrative and other operating expenses. Because an expense ratio reduces a fund's assets it reduces the returns investors receive.

Why Is Expense Ratio Important?

The expense ratio on a fund or ETF is important because it lets an investor know how much they are paying in costs by investing in a specific fund and by how much their returns will be reduced. The lower the expense ratio the better because it means that an investor is receiving higher returns on their invested capital.

How Is Expense Ratio Calculated?

The expense ratio is calculated by dividing total fund costs by total fund assets.

What Is a Good Expense Ratio for a Mutual Fund?

Mutual funds that invest in large companies should not have an expense ratio above 1% while funds that invest in smaller companies should not have an expense ratio above 1.25%. There are funds with expense ratios higher than this, and they can either be viewed as expensive funds or funds that provide a special service justifying their high cost.

The Bottom Line

Expense ratios are taken out of mutual fund and ETF returns to help pay for operations and fund management. The expense ratio charged to investors will vary depending on the fund's investment strategy and level of trading activity. In general, expense ratios have been declining steadily over time as competition for investor dollars has heightened. Actively-managed funds and those in less liquid asset classes will tend to have higher expense ratios, while passively-managed index funds feature the lowest expense ratios.

Article Sources
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  1. Investment Company Institute. "Mutual Fund Expense Ratios Down Sharply from a Quarter Century Ago."

  2. FINRA. "Funds and Fees."

  3. Vanguard. "Vanguard S&P 500 ETF."

  4. Fidelity. "Fidelity Contrafund." Accessed March 3, 2021.