Understanding Fund Expense Ratios: What You Need to Know

Do you have any idea how much of a fund’s expenses are being passed on to you as the investor? Well, that’s what the expense ratio will help you understand. A fund’s expense ratio indicates how much of its assets are being consumed by costs that are paid by investors.

Understanding the expense ratio figure is useful especially if you plan on investing in an actively managed mutual fund, a passively managed index fund, or an exchange-traded fund (ETF). 

Let’s dig a little deeper with the following questions:

• What kinds of expenses get bundled into an expense ratio?
• How is an expense ratio calculated?
• Why are some expenses higher than others?
• Might the expense ratio say anything about the quality of the fund?

Expense Ratios and How They Might Impact Returns

To recap, an expense ratio tells you what percentage of a fund’s total assets are being used to cover its operating costs. Think of it as the cost of doing business, and some of those costs are absorbed by the fund’s investors.

A fund calculates its expense ratio by dividing its total assets by total costs. The ratio is usually stated as a percentage, and expense ratios can vary. For example, if you look at a number of different funds, you may find expense ratios ranging from 0.25%, a relatively low ratio, to around 1.5% or higher, which may be considered quite high.

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How much might an expense ratio affect your returns? It can be significant. Imagine investing $100,000 into a fund that generates 4% in annual returns over a 20-year period.

• With no costs and fees, you may end up with a little over $219,000.
• With a middle-of-the-road expense ratio of 0.5%, your end result may be around $15,000 lower, not counting other costs and fees.
• And with a 1.5% expense ratio, your returns may be reduced by a little over $46,000, again, not counting other costs and fees.

The range and impact of expense ratios can be significant to your total return. So when you take the time to evaluate a fund’s strategy and performance, be sure to consider the costs as well before jumping in. 

But remember: fees such as expense ratios are only one dimension across which to assess funds. Two seemingly-similar funds with different expense ratios might have other differences in their composition, so it’s important to read a fund’s prospectus before making an investment.

What Kinds of Costs Go into an Expense Ratio?

An expense ratio covers a fund’s total annual operating expenses, most of which may go toward covering management, marketing, and distribution fees. Also included may be fees for accounting, administration, recordkeeping, custodial services, legal services, and even taxes. Of note, the general trend in recent years has been toward lower expense ratios. 

It takes a lot to manage a fund, and some funds may require more services and incur higher costs than others. This is why expense ratios vary from fund to fund. But within the fund, an expense ratio tends to remain relatively fixed. If a fund’s expense ratio is set to, say, 0.25%, that ratio tends not to change unless the fund’s board of directors decides to do so (in which case such changes will be reflected in the fund’s updated prospectus).

Why Are Some Expense Ratios Higher Than Others?

Each fund requires different services that often entail different costs. For instance, asset allocation strategies for actively managed mutual funds may require frequent “rebalancing.” Because of this they may have higher expense ratios than passively managed index funds. In general, mutual fund expense ratios tend to be higher than ETF expense ratios for similar reasons. 

Aside from a fund’s investment strategy (active or passive), other factors that may affect operating costs can include investment category and size. For instance, if a fund’s asset category is narrow or its total assets small, it may have a smaller base from which to meet expenses, and its expense ratio may be higher. In addition to these factors, individual funds also face unique internal costs that may or may not be easily transparent to investors.

How Might I Use the Expense Ratio to Help Evaluate a Fund?

Comparing funds can sometimes be like apples to oranges. Their assets, strategies, management requirements, historical performance, and operational expenses vary widely, and it can be difficult to reliably match corresponding pros and cons on a comparative basis.

However, it might help to compare expense ratios between funds that are similar in strategy, category, or size. For instance, you could compare two large-cap equity mutual funds or two semiconductor ETFs. You might even want to compare expense ratios across asset classes, such as an index mutual fund with an ETF benchmarked to the same index.

When you compare similar funds, the difference in costs might indicate the funds’ unique operational differences, but not necessarily the overall quality of the fund.

One more thing to mention—other potential costs. Although expense ratios may make up a significant portion of a fund’s costs, they’re not the total cost you pay for investing in a fund. If your fund is part of a 401(k) or 403(b) plan, you might need to take into account custodial administrative fees. And unless you're purchasing shares of no-transaction-fee (NTF) mutual funds or commission-free ETFs, you also have to consider broker commissions and other trading-related fees.