Expense Ratio of an ETF or Mutual Fund
The expense ratio is the percentage of the fund's assets that are used to cover management costs and other administrative fees. Look at this metric to get an idea of what a fund charges for its service.
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What is an Expense Ratio?
An expense ratio is the percentage of the fund's assets that are used to cover management costs and other administrative fees. For example, let's say an investor is considering two different ETFs (exchange-traded funds). Both have similar track records and are invested in the same types of assets. However, one has an expense ratio of 0.15% and the other has an expense ratio of 0.35%. That may not seem like a big difference, but over time it can add up.
So, if $10,000 is being invested, the first ETF will only cost $15 in fees per year while the second ETF will cost $35. That may not seem like a lot of money, but over the course of 10 years, the investor would end up paying at least $200 more in fees with the second ETF. The expenses are also deducted from the price of the ETF, so the money paid is not subject to the ETFs price appreciation.
The expense ratio can vary depending on the type of fund. For example, a passive ETF typically has a lower expense ratio than an active ETF because the amount of resources to manage an active fund is greater. All things being equal, a lower expense ratio is better for investors because it means more of the return is going into their pockets and not being eaten up by fees.
How Expense Ratios Work
When investing in a mutual fund or an ETF, it's important to understand how the expense ratio works. For every dollar that an individual invests into either type of investment, the firm managing the investment will charge a fee related to the costs of managing the investments, called an expense ratio. This is the cost of expenses to manage that fund and can typically range in the 0.10% to 0.75% range.
Comparing expense ratios can help investors choose between two similar investment options and save money over time, but it shouldn't be the only thing that investors consider when investing.
How Expense Ratios are Calculated
The calculation is extremely important to determine how much you'll pay with an expense ratio. There are two main ways that expense ratios can be calculated: by weight or by assets. The method used will affect the outcome of the ratio, so it's important to be aware of both.
The difference between these two methods is slight, but it will help get a more accurate picture of what is actually being paid for and the value of the total dollars going out the door.
Calculating Expense Ratio by Weight
When calculated by weight, the expense ratio is determined by taking the total amount of expenses for the fund and dividing it by the total number of shares outstanding. This method is typically used for mutual funds.
Expense Ratio = total amount of expenses for a fund / total number of outstanding shares
Calculating Expense Ratio by Asset
On the other hand, when calculated by assets, the expense ratio is determined by taking the total amount of expenses for the fund and dividing it by the total assets under management. This method is typically used for ETFs.
Expense Ratio = total amount of expenses for a fund / total assets under management
Total vs. Gross Expense Ratio
It's important to differentiate between the total and gross expense ratios when looking at how the fund's assets are being spent.
- The total expense ratio is the percentage of the fund's assets that are used to cover all management costs and other fees. This includes things like marketing and administrative costs.
- The gross expense ratio is just the percentage of the fund's assets that are used to cover the fund manager's salary and other operational costs.
So, why is this distinction important? Well, it's helpful to know how much of the investment is actually going towards the management of the fund. And, in general, investors will want to look for a fund with a lower total expense ratio.
Tip: A lower expense ratio means that more of the invested money is going towards actual investments, rather than fees.
Mutual Fund Expense Ratio Share Classes
Mutual funds bring an additional layer of information that investors must understand. This is because the expense ratio can vary from one share class to another.
Some funds have multiple share classes, each with a different expense ratio. For example, a fund might have an A class with an expense ratio of 1.00%, and a C class with an expense ratio of 1.50%. The difference in expense ratios can be significant, so it's important to fully understand how this works for the fund being considered.
Investors should also be aware that the expense ratio is just one of many fees that mutual fund companies charge. There are also sales charges, which can vary depending on how the fund is purchased. For example, some funds have a front-end load, which is a fee charged when the fund is purchased. Others have a back-end load, which is charged when the fund is sold.
Thankfully, sales charge and expense ratio are typically connected. This means that if one has a high expense ratio, it often will have a lower sales charge and vice-versa. This can help keep some of the fees in check, even if it looks like additional fees are just being tacked on top.
However, even if they are offset, keep in mind that all of these fees can add up so it's important to study and inquire about each aspect of the fund's fees before moving forward. This will help investors have a better grasp on what they are investing in and how the profits are both calculated and distributed.
What's a Good Expense Ratio?
There's a lot of variation between different types of funds if you're looking at how much you'll be charged via the expense ratio. Investors might see anything in the range of 0.10% to 0.75%. Generally, a good expense ratio will be less than 0.20% in most situations. It's a good idea to dive into the details and understand how the expenses are calculated and what they're being used for the fund you're interested in.
Bottom Line
All things are not created equal in expense ratios. In order to get the most out of any investment, it's important to compare the expense ratio of different ETFs and mutual funds by fully understanding how each is calculated. You can do this by comparing the quality of what the management team is offering versus the cost to you and see if the end results are worth the investment and fees you'll end up paying.
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