What Is an Expense Ratio? Definition, Example & Importance
A fund's expense ratio is calculated by dividing its annual costs by the total value of its assets.
What Is an Expense Ratio?
An expense ratio is a fee an investor pays annually to invest in a mutual fund or ETF (exchange-traded fund). Both mutual funds and ETFs are curated baskets of securities managed by companies that allow investors exposure to many different assets with a single investment.
Expense ratios, expressed as percentages, represent the proportion of someone’s total investment deducted annually to help pay for the fund’s management and administration. For example, if an ETF had an expense ratio of 0.07%, investors would be charged 70 cents per year for every $1,000 they had invested.
Expense ratios are called expense ratios because they are the ratio of a fund’s expenses to its total holdings, or assets. To an investor, an expense ratio is a fee paid to a fund manager for the convenience of not having to research and select from a vast array of securities individually.
How Are Expense Ratios Calculated?
Each fund’s expense ratio is calculated by dividing its expenses—which include things like salaries, taxes, record-keeping costs, and auditing fees—by the total value of its assets.
Expense Ratio Formula
ER = Fund Expenses / Fund Assets
How and When Are Expense Ratios Paid?
Expense ratios are annual fees paid by investors to funds, but investors don’t actually have to do anything to make these payments—they are deducted automatically from each investor’s balance. How often money is deducted depends on the fund, but whether it is deducted daily, weekly, or monthly, it still comes out to the same percentage on an annual basis.
Additionally, each fund’s expense ratio is included in the calculation of its net asset value (NAV), so investors don’t need to perform any additional calculations to determine what their returns will be after their expense ratio is paid.
Expense Ratio Example: Vanguard Information Technology ETF (VGT)
An investor interested in information technology stocks might be interested in the Vanguard Information Technology ETF—which trades under the ticker VGT—because it offers exposure to many leading tech companies via a single investment. But how much would this investment cost?
As of late 2023, VGT had an expense ratio of 0.10%, meaning that investors would have to pay $1 per year toward the maintenance of the fund for every $1,000 they had invested. This fee would be paid automatically out of each investor’s invested balance and would be incorporated into the fund’s listed net asset value, so no one would have to remember to subtract it from their annual gains (or add it to their annual losses).
What Is a Good Expense Ratio?
Expense ratios vary quite a bit between funds, but in general, they are lower than ever across the board, as increased competition between funds has driven ratios lower over time while fund investing has grown in popularity.
Actively managed funds usually have higher expense ratios than passively managed funds because portfolio decisions have to be made in real time by professional investors on a fund’s payroll. Passively managed funds usually just track an index or sector, so their expenses are lower.
The expense ratios of passively managed ETFs and mutual funds usually average around 0.05% to 0.3%, while the ratios for actively managed funds average between 0.5% and 1%.
Note: While ETFs typically only charge an expense ratio, mutual funds may charge additional fees like front and back-end loads. It’s important to understand a fund’s fee structure fully before investing.
Are There Funds That Don’t Charge Expense Ratios?
Funds that don’t charge expense ratios do exist. Here are just a few ETFs that, as of late 2023, had expense ratios of 0%.
- SoFi Select 500 ETF (SFY): Large-cap growth equities
- SoFi Next 500 ETF (SFYX ): Mid-cap growth equities
- BNY Mellon US Large-Cap Core Equity ETF (BKLC): Large-cap growth equities
- BNY Mellon Core Bond ETF (BKAG): Total bond market
- Gabelli Automation ETF (GAST): Technology equities
- Gabelli Commercial Aerospace and Defense ETF (GCAD): Aerospace and defense equities
- Gabelli Love Our Planet & People ETF (LOPP): Environmentally and socially conscious equities
- Pacer iPath Gold ETN (GBUG): Precious metals
- iPath Silver Exchange-Traded Notes (SBUG): Precious metals
Do Expense Ratios Really Matter? How Much Do They Affect Returns?
Since most expense ratios are quite low, and all are deducted automatically, it can be easy to forget about them. That being said, they can have a major impact on an investor’s returns.
Say there were two ETFs that held the same basket of securities in the same proportions. The first has an expense ratio of 0.05%, and the second has a ratio of 0.3%, and they both go up in value by 20% over the course of a year. If you invested $10,000 in the first, you’d have made $1,995, or 19.95%. If you invested $10,000 in the second, you’d only have made $1,970, or 19.7%.
This difference may seem small, but over many years of compounding gains, the difference would become significant. In the long term (say, 20 years), an investor overpaying for an ETF could miss out on a substantial amount of money.
What Is a Gross Expense Ratio? What Is a Net Expense Ratio?
A gross expense ratio represents all of the costs of operating a fund, whereas a net asset ratio takes into account any fees that have been waived or reimbursed. In other words, the net expense ratio is what investors actually pay for access to a fund, whereas the gross expense ratio is what they might have to pay for access to the fund if things like promotional reimbursements are discontinued.