Mutual funds and exchange-traded funds (ETFs) are popular ways to invest money and potentially build wealth, but it’s important to know how they work and the related expenses to invest in them. One key factor to consider is the expense ratio, which is an important metric that reveals how much investment returns are reduced by fees and other costs. We’ll explain mutual fund expense ratios, why they matter, as well as how to calculate them.

What Is an Expense Ratio?

An expense ratio is an annual fee that mutual funds and ETFs charge their shareholders to invest in the funds. Expense ratios cover the costs of operating the fund, such as administrative costs, management fees, and other expenses. The expense ratio is expressed as a percentage of the fund’s average net assets and is subtracted from the fund’s returns annually; however, selling shy of the year will likely still incur fees.

The expense ratio is outlined in the fund’s prospectus, a legal document that provides investors with information about the fund, its objectives and management, and the risks associated with investing in it. Investors should always read the prospectus before investing in any fund to fully understand the risks and rewards. According to The Balance Money, “Some fund prospectuses include two expense ratios: a gross expense ratio and a net expense ratio. The gross expense ratio amounts to all expenses associated with a fund, relative to the fund’s assets, including operating expenses, interest expenses, and other management fees. The net expense ratio represents fees collected after fee waivers and reimbursements.” When looking at your fund’s expense ratio, know that the net expense ratio is what you will actually pay to invest in the fund.

These fees can be easy to miss, as they don’t appear as a bill or on your statement. The fees are taken directly out of the total assets at the fund level prior to reaching investors individual share ownership. Another way to think about it is that the fees are distributed across the entire fund but are still passed through to shareholders. For more information, refer to the fund’s prospectus, visit the fund company’s website, or use the fund’s ticker symbol on a search engine such as Google. A financial professional should also be able to explain how the expense ratio will impact that specific fund.

How Is the Expense Ratio Calculated?

The expense ratio is calculated by dividing the total operating expenses of the fund by its average net assets, which are the total assets of the fund less any liabilities. The operating expenses include management fees, administrative costs, marketing costs, and other costs associated with running the fund. The expense ratio is expressed as a percentage; if you have an expense ratio of 0.55%, this means you would be charged $55 annually for every $10,000 invested in the fund. The formula for calculating the expense ratio is: expense ratio = total fund costs/ average net fund assets.

Why Is a Fund’s Expense Ratio Important?

Understanding expense ratios is important because it directly impacts your returns. A higher expense ratio means that you’re paying more to cover the costs associated with operating the fund, thus lowering your overall return. As your portfolio grows, these fees can further reduce your returns because of losing the effect of compounding interest for the expense ratios deducted.

What Is a Good Expense Ratio?

In general, a lower expense ratio is better. Finding a good expense ratio often depends on the type of fund in which you are investing. Active funds, like mutual funds, tend to have higher expense ratios than index funds or ETFs because they require more work to manage and employ a fund manager(s). Index funds tend to have lower expense ratios because they are passively managed. To learn more about the differences between mutual funds and index funds, click here.

According to the Investment Company Institute, “In 2021, the average expense ratio of actively managed equity mutual funds was 0.68 percent.” The same research also shows that the expense ratio for funds that are not actively managed, also known as index funds, is much lower—0.06 percent to be exact. Mutual fund expense ratios have been declining over the years. The Investment Company Institute also stated that “equity mutual fund expense ratios averaged 0.47 percent in 2021, compared with 1.04 percent in 1996. Hybrid mutual fund expense ratios averaged 0.95 percent in 1996 and fell to 0.57 percent in 2021; and similarly, bond mutual fund expense ratios averaged 0.84 percent in 1996 and fell to 0.39 percent in 2021.”

How to Find Funds with Low Expense Ratios

If you’re not working with a financial professional who can help you sort through the associated expenses of different funds, looking at funds based on major indexes, such as the S&P 500, is a good place to start, as they often have lower expense ratios.

Takeaways

Mutual fund expense ratios are a key component of investing in mutual funds. It is important to understand how they work and what they mean for your investments, as they affect your bottom line. Generally speaking, a lower expense ratio is better, but it’s also important to consider other factors, such as the type of fund you are investing in and its potential returns. By understanding mutual fund expense ratios and how they affect your investments, you can make more informed decisions about your investments.

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References

Investment Company Institute. (March 24, 2022). Mutual Fund Expense Ratios Down Sharply from a Quarter Century Ago. https://www.ici.org/news-releases/22-news-trends

Hayes, Adam. (September 12, 2022). Expense Ratio: Definition, Formula, Components, Example. Investopedia. https://www.investopedia.com/terms/e/expenseratio.asp

Anspach, Dana. (May 10, 20220). How Mutual Fund Expense Ratios Work. The balance. https://www.thebalancemoney.com/expense-ratios-paying-much-2388663