What is the Expense Ratio?
The Expense Ratio represents the total operating costs incurred by a fund as a percentage of its average value of net assets managed.
How to Calculate the Expense Ratio (Step-by-Step)
The expense ratio represents the proportion of a fund’s assets allocated to operating expenses per year.
In short, the expense ratio reflects the costs incurred to operate a specific mutual fund or ETF, such as overhead and administrative expenses.
The fund metric is particularly important to investors in mutual funds and exchange-traded funds (ETFs).
Each year, mutual funds and ETFs must pay operating expenses such as:
- Management Fees and Employee Salaries
- Administrative Expenses and Customer Support
- 3rd Party Fees (e.g. Accountants, Lawyers, Consultants)
- Marketing and Distribution Fees (e.g. 12-1B Distribution Fees)
- Overhead Costs (e.g. Office, Equipment, Utilities)
Expense Ratio Formula
The expense ratio formula consists of dividing a fundās total annual operating expenses by the average value of its total assets managed.
For example, suppose a mutual fund incurred $2 million in operating costs for a given year.
If we assume the fund managed $200 million in assets, its expense ratio comes out to be 1.0%.
- Expense Ratio = $200 million / $2 million = 1.0%
Expense Ratio and Impact on Returns
Considering the ratio compares expenses to assets managed, a higher ratio suggests that expenses are incurred for each asset managed by the fund.
- High Ratio: A higher ratio reduces a fundās adjusted returns, all else being equal.
- Low Ratio: On the other hand, a lower ratio implies the fund incurs fewer expenses to manage its assets.
A high expense ratio raises the minimum threshold in performance to generate the same returns as a fund with a low expense ratio. Rather than being directly charged to investors, operating expenses indirectly reduce the fundās total assets (and the returns to investors).
The expense ratio for an actively managed mutual fund usually ranges around 0.50%, but for passively managed investment vehicles, the expense ratio can be as low as 0.10%.
Sources of Fund Expenses and Fees
An actively managed fund’s operating costs are higher, especially management fees ā resulting in a higher expenses. Since a fundās operational costs are shared among its investors, a greater fund size means the fees will be spread out across more investors.
Other factors that investors must consider are the following:
- Transaction Costs: Purchasing and Sale of Securities (i.e. Commission, Brokerage)
- Sales Charge: Paid when āBuying Inā (i.e. Purchasing Unit Shares of Mutual Funds)
- Redemption Fees: Early Sale of Shares in Mutual Fund Before Specified Date
Mutual Fund Expense Ratio Calculation Example
Suppose you invested $400,000 into a mutual fund with an expense ratio of 0.50%.
Then the dollar amount paid each year to support the fundās operational costs is $2,000.
- Operational Expenses = $400,000 * 0.50%
- Operational Expenses = $2,000
While the $2,000 expense can appear marginal relative to the amount invested, these seemingly minor differences in fund cost structures can significantly affect long-term returns.