What is an expense ratio? The most important fee to know when investing in mutual funds or ETFs

Comparing the expense ratios different funds charge is key to determining how much your investment will actually return.OlegGr/Getty Images
  • An expense ratio is a fixed fee mutual funds and exchange-traded funds (ETFs) charge investors to cover operating costs.
  • Actively managed mutual funds tend to charge higher expense ratios than passively managed ETFs.
  • While relatively small — typically ranging from .25% to 1% — expense ratios can significantly affect a fund's return, especially over time.

Mutual funds and exchange-traded funds (ETFs) are valuable tools for long-term investment. They are managed by professionals whose main focus is building the value of the fund, helping you diversify your portfolio, and enabling you to buy into companies and securities that you may not have been able to on your own.

As beneficial as it is to invest in these kinds of funds, here's the thing: They also cost money. Though both mutual funds and ETFs are considered low-cost investment products, you'll find a number of fees associated with managing a fund on your behalf.

The main fee you should know before signing any paperwork? The expense ratio. Here is a closer look at the role of expense ratios and what you need to know when evaluating buying into a fund.

What is an expense ratio?

An expense ratio is a fee that covers the total cost of the annual operating expenses for investing in a mutual fund or an ETF. It is expressed as the percentage of your investment that goes back to the fund.

You may also see these fees listed as "annual fund operating expenses."

Expense ratio is an umbrella term that can include a number of different fees that help keep the fund working for you, including:

  • Portfolio management
  • Administrative and maintenance costs
  • Distribution or transfer of assets
  • Legal and accounting expenses

While the expense ratio is the main fee you should know, it's not the only one. Expense ratios don't include transactional fees or costs related to sales, such as shareholder fees charged to buy or sell fund shares or to compensate brokers. They are strictly operational expenses.

Expense ratios for ETFs tend to be lower than those for mutual funds. One reason for this is that many ETFs basically mimic the holdings of major indexes, which means they don't need as much attention by an investment professional. Many mutual funds also follow this approach, but others are more active in researching and investing assets. These funds use more time and resources and the expense ratio is usually higher as a result.

How expense ratios are calculated

Expense ratios are calculated as a percentage of average net assets that are being managed.
While the formula is the same, the actual expense ratio charged can vary greatly from fund to fund.Shayanne Gal/Business Insider

For example, if you have $20,000 in a mutual fund that has an expense ratio of 0.5%, your operational fees would be $100 for every $20,000 invested. The amount would be deducted from your fund's assets.

This may not seem like much to pay a financial professional to grow your investments. But when you're looking at maintaining a fund for decades, a few expense ratio points can translate into large differences in net assets.

Consider this example. You have four mutual funds, each with $20,000 in assets and a different expense ratio: 0.25%, 0.50%, 0.75% and 1.0%. Assuming each earns a 5% annual return and no additional contributions are made to the funds, a 0.25% difference in expense ratios results in thousands more paid in operational fees, with a significant impact on the funds' growth. At the end of 20 years, each fund would be worth:
  • Fund 1: $50,595.35 (.25% expense ratio)
  • Fund 2: $48,234.28 (.5% expense ratio)
  • Fund 3: $45,978.13 (.75% expense ratio)
  • Fund 4: $43,822.46 (1% expense ratio)

Though expense ratios are a necessary evil of investing in managed funds, the percent charged varies from fund to fund. Investor demand has caused more competition among fund providers and has resulted in a 20-year downward trend in average expense ratios in the US.

You can research different funds offered by investment companies, such as Vanguard or Fidelity, and comparison-shop funds that offer the most benefit for the lowest rates. Another option is working with a financial planner or registered investment advisor who can help guide you toward products that make sense for your goals. Some things to look out for include:

  • How far is the expense ratio above or below the industry average?
  • How does the expense ratio dovetail with those of similar funds or fund families?
  • How much involvement will the portfolio manager have with investing the fund's assets? More involvement usually means higher fees.
  • What other services will the firm provide during the course of managing your fund?

What is a good expense ratio?

Finding the national average for expense ratios is a good place to start when evaluating whether or not you're being charged a good rate. According to independent investment research firm Morningstar, the 2019 average asset-weighted expense ratio in the US was 0.45%.
You should also take a fund's management approach into consideration. As discussed earlier, funds are managed either passively or actively, which results in different expectations for a good expense ratio:
  • With passive management, the fund aims to keep pace with specific indexes, such as the S&P 500. Trades and management of the portfolio don't require much time or attention, which is why they're considered passive and generally have lower expense ratios. The 2019 average for passive funds was 0.13%.
  • With a fund that is actively managed, the portfolio manager invests time and resources to find the best securities to deliver the desired return. Costs for this level of management are understandably more than with a passive management option. The 2019 average for active funds was 0.66%.

These averages are a good yardstick to use when evaluating funds. However, you may find that many larger investment firms are able to provide rates markedly lower than the national average, says Daniel Patterson, a certified financial planner and owner of Sweetgrass Financial Planning in Mount Pleasant, SC.

For example, Vanguard's average expense ratio is 0.10% and Fidelity is currently offering some passive index funds with 0% expense ratio. Patterson says this is possible because such firms have enormous resources that enable them to recoup expenses through avenues other than client fees.

Where to find your fund's expense ratio

Investment firms are required to provide a prospectus when you use their services to buy shares of a fund or other types of investment products. A prospectus is a document that discloses all of the fees and expenses, performance, risks, goals, and other vital information about a fund. This is the document that will show you the expense ratio for your fund.

Firms are also required to provide shareholders with semi-annual and annual reports that show how their funds and investments are performing. There should be a listing of expenses charged and paid on these reports and a breakdown of how those numbers were calculated.

The financial takeaway

Every mutual fund has expenses associated with it and you will find an expense ratio for every kind of managed fund. The expense ratio consists of annual fees that are charged to pay for the operational expenses for your fund. This is usually a percentage of the annual net assets in the fund and is deducted directly from the fund's gross assets. You will get a report from your investment firm twice a year that discloses how much your fund has made and what expenses have been paid.

Like many other financial products, funds are priced competitively. You may find large differences in fees and performance from fund to fund. But even a small difference in a fund's expense ratios can result in significantly more fees paid or saved over time.

If you're not clear about what fees you'll be charged as a shareholder, always ask. In the end, take stock of what your investment goals are and choose the fund that makes the most sense for your situation and investing timeline.

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