What is an Expense Ratio and What’s a Good One?

An expense ratio is a measure of the recurring costs involved in operating and managing an investment fund relative to assets under management. It represents the annual fees and expenses charged by the fund manager expressed as a percentage of the capital invested. Expense ratios are a key consideration when selecting and evaluating mutual funds, ETFs, and other managed investment products.

What is an Expense Ratio?

The expense ratio measures the total annual fees and operating expenses charged by an investment fund as a percentage of assets under management. It encompasses all recurring costs involved in operating the fund such as management fees, administrative expenses, legal and compliance costs, accounting, printing, custodial services, and more.

The expense ratio does NOT include trading costs, sales loads, or redemption fees.

Expense ratios provide an easy way for investors to compare the costs of different investment funds at a glance. Lower expense ratios mean more of an investor’s capital is invested and generating potential returns instead of being eaten up by fees. Over the long run, high expense ratios can significantly degrade cumulative investment gains.

Mutual funds and exchange traded funds (ETFs) are required to prominently disclose their expense ratio, typically listed as a percentage. The average actively managed mutual fund has an expense ratio of around 1% whereas index funds and ETFs average closer to 0.5% or less.

How Do Expense Ratios Work?

Expense ratios represent the annual fees collected by the fund manager expressed as a percentage of total assets under management.

The dollar amount of fees collected rises and falls proportionately with the asset base, while the expense ratio itself generally remains constant.

For example, a fund with a 1% expense ratio and $100 million of assets under management (AUM) would collect $1 million in annual fees:

• • AUM: $100,000,000

• Expense ratio: 1%

• Annual fees collected = AUM x Expense ratio = $100,000,000 x 0.01 (1%) = $1,000,000

If the fund’s assets double to $200 million while the expense ratio stays at 1%, the annual fees would also double to $2 million. This allows funds to earn more as they grow while keeping the expense ratio steady.

Investors pay the listed expense ratio annually as long as they remain invested in the fund. The fees are deducted from the fund’s assets before performance returns are calculated.

READ ALSO: What is a Leverage Ratio?

Types of Fees Included in the Expense Ratio

The expense ratio encompasses a variety of recurring fund costs including:

Management Fees – Payment to the investment manager for portfolio advisory services and normal business operations. This typically represents the largest portion of expenses.

Administrative Fees – Costs for legal, accounting, printing, mailing, filing, recordkeeping, and custodial services.

Distribution Fees – Expenses for marketing and selling fund shares, including advertising and compensating brokers.

Transaction Fees – Costs to buy and sell securities in the portfolio, including trading commissions.

Redemption Fees – Fees some funds charge shareholders when selling fund shares, typically to discourage short-term trading.

The sum of these recurring expenses makes up the total expense ratio. Note that sales loads, brokerage commissions, and interest costs are not included in the expense ratio calculation.

Average Expense Ratios by Fund Type

Expense ratios can vary based on the investment strategy and types of securities held by the fund. Here are typical expense ratio ranges for common fund varieties:

Actively Managed Mutual Funds – 0.5% to over 1.5%. Actively managed stock and bond funds average around 1%.

Equity Index Mutual Funds – 0.1% to 1%. Lower costs because passive strategies require less management and research.

Bond Index Funds – 0.05% to 0.3%. Tend to have the lowest costs due to simplicity of passively tracking bond indexes.

Target Date Retirement Funds – 0.5% to 1%. All-in-one diversified asset allocation drives fees lower than actively managed funds.

Money Market Funds – 0.1% to 0.5%. Conservative liquid portfolios have minimal trading and oversight needs.

Exchange Traded Funds (ETFs) – 0.05% to 1%. ETFs tracking major indexes have expense ratios below 0.10% while actively managed ETFs approach 1%.

As a general rule, index-based strategies have lower expense ratios than actively managed funds in the same asset class.

Factors Impacting a Fund’s Expense Ratio

Several factors influence the expense ratio of an investment fund:

• Fund Type – Actively managed stock funds have some of the highest expense ratios. Index funds and ETFs tend to have the lowest.
• Manager Skill – Top performing star managers can charge higher fees, driving up the expense ratio.
• Fund Complexity – More complex investment strategies, research, and trading tend to increase fund expenses.
• Assets Under Management – Large asset bases allow fixed costs to be spread over more AUM, reducing expense ratios.
• Manager Deal – Managers may cut fees to attract asset inflows, lowering expense ratios.
• Share Class – Multiple share classes of a fund can have different expense ratios.

Actively managed funds focused on less efficient assets like high-yield bonds or small cap stocks often carry higher expense ratios as well.

READ ALSO: What is Hedging and How Does it Work?

Evaluating and Comparing Expense Ratios

When selecting investments, investors should evaluate a fund’s expense ratio relative to category peers and benchmarks. Here are some tips:

• Compare to similar fund categories – A 1.5% ratio may be high for an S&P 500 fund but reasonable for an actively managed emerging markets fund.
• Check ratios over time – Has it been steady or creeping up? Rising expenses should raise questions.
• Consider returns net of fees – A high-fee manager must clear a higher performance hurdle to beat an index fund after fees.
• Assess value added – Make sure higher fees are justified by clear value-add from the manager.
• Weigh tax efficiency – Expense ratios matter more for taxable accounts versus retirement accounts where taxes are deferred.

Let’s look at guidelines for spotting good and bad expense ratios.

What is a Good Expense Ratio?

A good expense ratio delivers value and maximizes returns net of fees. Some features of a well-managed, low-cost fund:

• Actively managed stock/bond funds: Below 1.0%
• Index-based stock/bond funds: Below 0.5%
• Money market and bond index funds: Below 0.25%
• Very broad, diversified index ETFs: Below 0.10%
• Stable or downward trending expenses over time
• Returns consistently in top half or quartile of comparable category after fees

Of course, costs are just one factor. Investors should consider the full picture including performance, risk, manager tenure, investment process, and more. But prudent fee management is a good sign.

Red Flags to Avoid in Expense Ratios

Watch out for the following red flags when evaluating expense ratios:

• Ratio over 1% for passive index funds or ETFs tracking major indexes
• Double the industry average for a fund category without justifying value
• Sharply escalating fees over past 3-5 years
• Excessive marketing, distribution, and accounting fees
• Poor risk-adjusted returns after expenses
• Higher costs than similar “clone” ETFs or index funds
• Vague or evasive answers from manager about expenses
• Hidden back-end costs not in expense ratio

Expenses matter most when all else is equal between investment choices. But high costs for no added value require a very careful look.

Minimizing Expense Ratios as an Investor

Here are some tips for investors to minimize costs and maximize returns when investing:

• Favor index funds and ETFs over active funds in efficient assets like large cap stocks
• Consolidate assets with one or two fund managers to qualify for lower tiers and scaling discounts
• Negotiate lower advisory fees for large accounts
• Avoid funds and share classes with sales loads and 12b-1 distribution fees if possible
• Invest through tax-advantaged retirement accounts to defer taxes on higher pre-fee returns
• Reinvest dividends and capital gains rather than pay taxes on distributions
• Use loss harvesting and tax efficiency strategies to offset costs
• Do not overtrade or chase past returns, which amplifies costs

While fees should not be the sole focus, prudent strategies can help investors minimize expenses and maximize after-fee returns.

To Recap

The expense ratio represents the total recurring fees charged to manage and operate an investment fund. Carefully monitoring and minimizing expense ratios where possible allows investors to maximize performance on net returns. While fees are just one consideration, prudent management and oversight of fund expenses provides an important protection for investors’ capital.

Frequently Asked Questions

How are expense ratios paid?

Expense ratios are automatically deducted annually from the fund’s assets before any performance returns are calculated. Investors do not directly pay the expense ratio. It is withdrawn proportionately from all investors in the fund.

Are expense ratios fixed?

Expense ratios tend to be relatively stable but can gradually increase or decrease over time. Managers try to avoid sudden fee hikes that could spark outflows. Changes in assets under management also impact the total fee amount.

What is a good expense ratio for an index ETF?

For major index ETFs like the S&P 500, a good expense ratio benchmark is around 0.05% to 0.10% or less. Actively managed ETFs average over 0.50%. Anything over 1% for an ETF raises concerns.

Do all mutual fund fees get included in the expense ratio?

No, the expense ratio only covers annual recurring management and operating expenses. Sales loads, brokerage fees, interest costs, and non-recurring expenses are omitted from the reported ratio.

Are expense ratios negotiable?

Managers will sometimes negotiate lower fees for very large accounts and institutional investors. But expense ratios are generally fixed for a given fund and share class. Investors can vote against excessive fee hikes though.

How are expense ratios disclosed to investors?

Funds are required to prominently list their expense ratio in the fund prospectus and investor reports, usually as a percentage. Investors can easily compare costs between potential investments.

Should expense ratios always be minimized?

Lower expenses maximize returns but are not the only consideration. Investors should ensure higher fee funds provide commensurate value through factors like risk management and market outperformance.

In another related article, A Beginners Guide to Interest Rates