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What Are Expense Ratios?

An expense ratio is the total cost an investor must cover each year to own shares of a fund. Here’s how they work and what impact they have on your portfolio.

Mutual funds and exchange-traded funds (ETFs) are securities that help you build a diversified portfolio and earn sustained returns over time. However, they also present a recurring cost — expense ratios. In simple terms, this is what it will cost you to own shares of one of these funds annually.

It’s crucial to be aware of expense ratios and how they impact your returns. This will enable you to understand your investment portfolio and more easily communicate with your financial advisor or fund manager, if necessary. In this article, we’ll outline how expense ratios work, why they matter, and what influence they may have.

Key Takeaways

  • The expense ratio represents the total cost, expressed as a percentage of owning shares of a fund.
  • Expense ratios include costs to operate and manage a fund, including distribution and marketing.
  • Trading costs are not a component of expense ratios.
  • For investors, a fund’s ratio is significant because it can hurt one’s returns.
  • Expense ratios are calculated annually by dividing the total of the fund’s expenses by the total value of its assets under management.

How Expense Ratios Work

When you own shares of a mutual fund or ETF, you’ll be responsible for paying your slice of the administrative or custodial costs to manage the security. Because these expenses can have an impact on one’s returns, investors keep track of the overall cost to own shares of a fund via its expense ratio. This metric is expressed as a percentage of assets under management (AUM) or the fund’s net assets.

As an example, consider a mutual fund that has a 1% expense ratio. In this case, 1% of the fund’s assets are used to cover operating expenses. To express it in terms of dollars, imagine you invested $5,000 into this same fund. This would require you to pay $50 for that amount.

You can find a fund’s expense ratio in its prospectus. This is a document that discloses important information about the fund, including who manages it and what it costs to own shares. To find it, you can visit the fund’s website or, in many cases, through your broker.

Costs It Includes

Expense ratios are made up of the costs associated with running and maintaining a mutual fund or ETF. In simple terms, these are for fund management and administration. These ensure a fund can run effectively, gain new shareholders, and sustain returns for owners.

An important cost that expense ratios factor in is the 12b-1 fee. This is an annual marketing and distribution fee that helps mutual funds and ETFs gain new shareholders, as well as provide services to owners. Additionally, funds may pay broker-dealer firms to distribute their shares to investors. The name 12b-1 refers to the SEC rule with the same name that enables funds to pass these costs on to shareholders.

To give you a more specific breakdown of individual costs that may be part of a fund’s expense ratio, consider the following list:

  • Fund management
  • Administrative costs
  • 12b-1 fees – marketing and distribution fees paid to brokers that sell fund shares
  • Legal expenses
  • Miscellaneous expenses

Costs That Aren’t Included

There are, however, additional costs associated with owning shares of a fund that don’t contribute to its expense ratio. Per Jung Seh, CFP, a financial advisor at Bogart Wealth, “[T]ransaction fees, exchange and regulatory fees, and any other fees that are not associated with direct management of the mutual fund or ETF are not factors in the calculation of expense ratios.” As Seh explains, an expense ratio only includes costs that a fund needs to operate. Other costs, such as for trading shares of a fund, aren’t included.

Expense Ratio Calculation

A fund calculates its expense ratio by tallying up the total amount of costs it covers to manage it. Then, it divides that number by the total value of the fund’s AUM. For example, if a fund has $500 million AUM and costs $5,000,000 to run. In this case, it would have a 1% expense ratio.

Keep in mind that, while a fund’s AUM and annual expenses may shift slightly, expense ratios tend to stay predictable over time. However, the more shares you buy, the more you’ll have to pay annually. This is because what you pay is dependent on the dollars you have invested multiplied by the expense ratio percentage.

Why Expense Ratios Matter to Investors

Expense ratios are a crucial component to pay attention to when you’re investing in mutual funds and ETFs. Seh warns that they “could be a factor to your bottom-line return.” While your funds may be generating positive returns overall, the cost to own shares may be significantly cutting into your profits.

Seh shares that, in her experience, she’s witnessed “expense ratios near 1% on very conservative portfolios that were only returning about 2-3%.” While this is the case, however, she adds that “high expense ratios are more seen with specialized funds that require more active management, like commodities that typically seek higher returns.” In simple terms, funds that take more effort to manage and distribute will have a commensurate expense ratio as a result.

Because a fund’s expense ratio can have a significant impact on your returns, it’s an important consideration before deciding to buy shares. Whether you work with a financial advisor or trade on your own, it’s a key metric to be aware of. As mentioned earlier, you can find a fund’s ratio in its prospectus, which is typically available on its website or through a brokerage firm.

Managing Impact on Portfolio

While expense ratios do affect your portfolio, there are steps you can take to manage or minimize the impact. It’s important to know if you’re overpaying to own shares of a fund. Most ratios hover between .01% to 1%. Anything on the higher end is usually, as Seh points out, an actively managed fund that attempts to gain larger returns for shareholders.

When you choose to add any security with an expense ratio to your portfolio, you should decide “if you are an active investor or a passive investor,” says Seh. This is because funds that actively seek out large returns require more attention and, thus, a higher expense ratio. However, if this aligns with your goals, it isn’t necessarily a bad path to invest.

Seh also explains that with a “self-directed retail account,” you’ll end up paying “higher expense ratios” than if you had a “managed account.” In this instance, you should consider what’s most important to you. If you value total control over your account and portfolio, then you’ll need to prepare to pay higher expense ratios.

Finally, despite expense ratios affecting your returns, “the diversification” provided by mutual funds and ETFs “could lower the overall risk” in your portfolio, says Jung Seh.

It’s best to conduct thorough research and speak with a financial advisor before deciding how you’d like to invest. To find a vetted professional near you, we recommend using this free matching tool, which will present you with fiduciary options that align with your goals.

Frequently Asked Questions

How do I calculate an expense ratio?

To calculate an expense ratio, a fund takes the total cost to operate the fund and divides it by the total (AUM). If you’d like to know how much you’ll end up paying annually, you simply multiply the dollar amount you invested by the fund’s expense ratio percentage.

Do mutual funds have expense ratios?

Yes, mutual funds have an expense ratio that shareholders must cover. This represents the overall cost to own shares of a given fund. To find this metric for a given fund, it will typically be present in its prospectus.

What is a normal expense ratio for an ETF?

For both mutual funds and ETFs, expense ratios normally sit between 0.01% and 1%. Generally, one will be on the higher end if it’s an actively managed fund that requires more effort on the part of the fund manager.