What is an Expense Ratio (ER)?

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Definition:

An expense ratio is a measurement of how much mutual fund investors pay in administrative and fund management costs.

🤔 Understanding expense ratios

An expense ratio measures the administrative and management costs for a mutual fund. Mutual funds hold a variety of securities (stocks, bonds, or other financial assets), letting investors purchase shares in one thing (the fund) to easily diversify their portfolio. Managing a fund takes effort and skill and overhead, so fund managers need to be compensated for their work and various administrative costs. Expense ratios measure the amount that mutual fund investors pay toward these costs. Typically, funds quote expense ratios as a percentage of the average assets under management (AUM) per year. Investors don’t pay the cost out of pocket, instead, the price of the fund’s shares reflect the fees.

Example

Imagine someone purchases $1,000 worth of shares in a mutual fund with an expense ratio of 0.5 percent. In theory, over the course of one year, the investor pays $50 as part of the expense ratio. In reality, the investor will pay slightly more or less as the value of each share rises or drops from day to day. Each day when the fund calculates the price of a share, it subtracts out the cost of the expense ratio.

Takeaway

An expense ratio is like giving someone a slice of pizza…

When you buy a pizza, it’s usually cut into multiple slices. You can give one of the slices, or a percentage of the pizza to another person, in exchange for them doing something for you, like helping you move. When you buy shares in a mutual fund, you’re giving them a percentage of the money you invested (a slice of the pizza) for managing the investment portfolio for you.

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What is an expense ratio (ER)?

An expense ratio is a fee charged on certain types of investments, typically mutual funds and exchange traded funds (ETFs).

Mutual funds invest in a variety of stocks, bonds, and other securities. Investors can buy shares in the mutual fund to, in effect, diversify their investment across all of the securities that the mutual fund holds. This makes it much easier for individual investors to diversify their portfolios while reaching their target mixture of stocks, bonds, and other securities.

Mutual funds take effort and money to run. The fund managers have to decide what securities to buy and what securities to sell to provide the best possible return for the fund. Even for passive funds, such as index funds, which aim to track a specific index and only trade to continue tracking their target index, there are management costs. With both passive and active funds, the manager needs to handle the income and outflow of money as investors buy and sell shares. There are also many regulatory and recordkeeping requirements.

Typically, the expense ratio is expressed as a percentage. Investors pay that percent of their invested assets each year. So, if a mutual fund has an expense ratio of 0.5%, investors pay 0.5% of their invested assets each year.

What does the expense ratio tell you?

An expense ratio tells you the annual management fees (as a percentage of assets) that you must pay for investing money in a mutual fund or ETF.

Some mutual funds charge one-time fees, such as loads, which you pay when you buy or sell shares. Often, these cover sales commissions for the people selling you the shares. These are one-time expenses that you can plan for and in some cases work around or avoid. However, you cannot avoid mutual fund or ETF expense ratios. You pay the cost associated with the expense ratio every day that you leave your money invested in the mutual fund.

Knowing the expense ratio for a mutual fund is important because it has a major impact on your returns, especially over the long-term. If the securities that a mutual fund holds increase in value by 10% over the course of a year, the fund’s shares won’t appreciate by 10%. Instead, they’ll gain roughly 10%, minus the expense ratio. The higher the expense ratio, the lower the overall gain.

All in all, the expense ratio tells you how much you pay for the convenience of investing in a fund.

What are the components of an expense ratio?

Expense ratios account for many of the costs of running a mutual fund. Some of the costs included in the expense ratio are:

  • Advisory services
  • Legal costs
  • Accounting costs
  • Dividend and interest charges on borrowed shares
  • Reporting costs
  • Fund distribution costs
  • Accounting fees
  • Plan custodian fees for 401(k)s

The expense ratio of a fund does not include transaction fees or loads, which are typically one-time, rather than ongoing fees.

How do expense ratios work?

Expense ratios work by combining different fees and costs that a fund incurs into a single percentage that investors can use to estimate how much they will pay to invest in the fund.

There are a lot of costs related to operating a mutual fund or Exchange Traded Fund (ETF). It would be very difficult for individual investors to look at these costs and compute how much they must pay to handle each of these costs, so an expense ratio makes the fee structure for a fund clearer.

Because expense ratios are expressed as a percentage of assets under management, investors can calculate approximately how much they will pay to invest each year by multiplying their investment by the expense ratio.

Another way to look at it is that the expense ratio reduces the fund’s returns by an amount equal to the expense ratio. If a mutual fund’s holdings gain 10% over a year, but the fund charges a 0.25% expense ratio, each share will only gain roughly 9.75% in value.

How are expense ratios paid?

Expense ratios are fees that you pay for investing in a mutual fund, but you don’t have to pay the fee out of your pocket. Instead, the mutual fund automatically accounts for the fee when it calculates its share price at the end of each day.

Unlike stocks, bonds, or other securities, when you place a buy or sell order for a mutual fund, the order goes through after the end of the trading day after the fund calculates the current value of a single share. That means that mutual fund prices only change once per day.

When calculating the value of a share at the end of the day, the fund manager deducts the daily cost of running the fund.

For example, if a fund’s price at the start of the day is $10 and all of its holdings maintain the same value throughout the day, the price of a share at the end of the day will be $10, minus the cost of running the fund that day. If the fund’s expense ratio is 0.5%, the daily fee is roughly 0.00136% (the expense ratio divided by 365 days in the year), so the cost of a share at the end of the day will be:

$10 (1 – 0.0000136) = $9.99864*

If the fund’s holdings don’t change in value for an entire year, then the value of a share will drop by 0.5% over the course of the year to:

$10 (1 – 0.005) = $9.95*

ETFs are priced differently because investors can trade them at whatever price they desire on the open market. That means that you can buy and sell ETFs in real time instead of just at the end of each trading day.

However, most ETFs tend to trade close to the actual value of their holdings because of the creation and redemption mechanism, which lets large investors redeem ETF shares for their underlying securities or trade in securities to create new shares of the ETF. This opportunity for arbitrage means that ETF prices generally settle near their actual value.

How is the expense ratio calculated?

To calculate the expense ratio for a fund, the fund’s managers divide the total cost of managing the fund by the fund’s assets. Because the total value of the fund’s assets can change over the course of the year as investors buy and sell shares, the calculation typically uses the average asset value for the year.

For example, if a fund costs $1M to manage and has $100M under management, that fund’s expense ratio is:

(1,000,000 / 100,000,000) 100 = 1%*

Some of a fund’s management costs will be fixed costs, while others can increase as the size of the fund increases. This means that having more assets under management can help a fund lower its expense ratio by spreading the fixed costs across more assets.

What is a good expense ratio?

Expense ratios are a fee that investors must pay, so generally, the lower the expense ratio, the better. However, there are very few funds that charge no expense ratio whatsoever.

Generally, the expense ratio of a fund depends on the type of fund. Actively managed funds (funds with managers who regularly buy and sell shares) that aim to beat the market charge a higher ratio than passive funds that aim to track a specific financial index.

As of 2019, a US News report found that the average expense ratio for an actively-managed fund was 0.66%. Passive funds, such as index funds, charged far less, averaging 0.13%.

If you have access to a retirement account like a 401(k), keep a close eye on the expense ratios of the available funds. The average cost of investing in a fund in a 401(k) was 0.45% in 2019.

Whether you feel like the expense ratio a fund charges is worth paying depends on your investing goals and opinions about the fund’s management. If you think a fund’s manager can consistently beat the market, you may be willing to pay a higher expense ratio than the average.

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