What Is an Expense Ratio and How Does It Work?

What Is an Expense Ratio?

An expense ratio is essentially the annual fee that mutual funds and exchange-traded funds (ETFs) charge their shareholders. The ratio, which is expressed as a percentage of the fund's average net assets, reflects the fund's operating costs.

In other words, a low expense ratio indicates that the fund's costs are low relative to its assets, and the opposite is true for high ratios.

Because a fund's operating costs are passed on to the shareholders, the expense ratio has a direct impact on your return on investment. As a result, it's important to compare expense ratios when shopping for mutual funds and ETFs to maximize your return.

What's Included in Expense Ratio?

Mutual funds and ETFs typically break down their expense ratios into the following cost categories:

• Management fee: This represents the amount paid to the fund's managers, who make decisions about the makeup of the fund and when to make trades. Actively managed funds, where managers buy and sell securities more regularly, typically have higher management fees.
• 12b-1 distribution fee: This charge is for the fund's marketing expenses, which include advertising fees, certain shareholder services and sometimes employee bonuses.
• Other expenses: This category includes all other operating expenses for the fund, though there's rarely a clear breakdown of those costs.

How to Calculate an Expense Ratio

Mutual funds and ETFs will calculate their expense ratio for you, so you don't have to worry about hidden costs. When evaluating a fund to determine whether to include it in your portfolio, the expense ratio should be clearly displayed.

With that in mind, here's a quick summary of how a fund's expense ratio is calculated:

Expense ratio = Total costs to operate the fund / Average net assets under management

For example, let's say a mutual fund has $250 million in assets under management, and in one year, it incurs the following expenses:

• Management fee: $1 million
• 12b-1 distribution fee: $300,000
• Other expenses: $200,000

To calculate the fund's expense ratio, you'll add up the total costs ($1.5 million), then divide that by $250 million, giving you a ratio of 0.6%.

What Is a Good Expense Ratio?

As you compare different mutual funds and ETFs, knowing what the average ratios are for each type of fund can help you determine whether an individual fund's ratio is a good one or not.

Here are some averages for stock funds to help you in your analysis:

Most mutual funds are actively managed, while most ETFs are index funds that track a specific benchmark index.

It's important to note, though, that while comparable mutual funds charge a lower expense ratio on average, they may also come with load fees, which are commissions charged when you buy or sell your shares in the fund. In contrast, ETFs don't charge load fees, so they still can be a cheaper option overall.

Also, funds that specialize in other types of investments may have higher or lower averages. Bond funds, for instance, typically charge a lower expense ratio compared to stock funds.

If you're looking for non-stock funds, be sure to compare average expense ratios for similar funds in that asset class.

The Bottom Line

As you decide what to include in your investment portfolio, it's important to align your choices with your overall investment strategy and goals. While mutual funds and ETFs can be a great way to diversify your portfolio, it's important to understand the costs associated with these investment options, particularly the ongoing cost of an expense ratio.

Take your time to research and compare multiple funds to determine the right fit for you. If you're struggling to decide, consider consulting with a financial advisor who can provide you with personalized guidance.