What is an Expense Ratio?

An expense ratio is the relationship of a fund’s total assets to other administrative and operating expenses. The expense ratio is taken from the fund’s gross return, cutting into potential profit margins. A fund with a low expense ratio is an attractive option for investors looking to maximize returns. Read on to understand how to calculate expense ratios and what to look for to protect your asset value. 

How Does an Expense Ratio Work?

An expense ratio is the relationship between the fund’s expenses and its gross return. Expense ratios can be expressed as a gross expense ratio, net expense ratio and after-reimbursement expense ratio. Generally, expenses include management fees, operating costs and others. Funds deduct expenses from the fund’s gross return to pay the fund manager and other expenses. 

To calculate the expense ratio, you divide the fund’s operating costs by the average dollar value of fund assets under management (AUM). 

Expense ratio = operating expenses / average AUM

It’s important to consider the expense ratio to determine whether a fund is an appropriate investment after fees. Generally, index funds have some of the lowest expense ratios, which means you can earn more proportionately. 

Components of Expense Ratio

Components of an expense ratio are the fund investment manager’s salary and management fees as well as other operating expenses. Here’s what you should consider. 

Management Fees

Management fees include the fund manager’s salary and other fees associated with the fund’s operations or the costs to manage the investment portfolio.

Operating Expenses

While there’s some overlap between management and operating fees, operating fees are typically associated with administrative and general operations expenses. These costs related to an investment strategy’s day-to-day management and operation include legal fees, audit costs, tax expenses and third-party administration costs. Other examples of common operating expenses in investment funds include:

• Rent
• Salaries and wages
• Accounting and legal fees
• Bank charges
• Sales and marketing fees
• Office supplies
• Repairs
• Utility expenses

Other Expenses

Other expenses are any additional costs associated with the fund that aren’t included in management or operating expenses. Additional expenses will contribute to the expense ratio. These expenses may vary across different investment vehicles. 

What’s a Good Expense Ratio?

An actively managed fund’s average expense ratios range from 0.5% to 0.75%. For passive funds or index funds, look for an expense ratio of around 0.2% or less. The expense ratio could be as low as 0.02% or less on some index or passive funds. Expense ratios greater than 1.5% are high and can cut into returns.

Importance of Comparing Expense Ratios

Expense ratios can impact investment returns. If an investment returns only 3% one year and the expense ratio is 1.5%, it’s unlikely the investments will stay ahead of inflation. Compare expense ratios of similar investment options. In the long term, saving 1% in an expense ratio can mean thousands of dollars more in your accounts.  

If you have $100,000 invested with an average annual return of 7% at the end of 30 years, you could have $761,225.50 without any additional contributions. That’s a great saving rate. But an average increase of just 1% would mean you’d have over $1 million at the end of 30 years. Over 30 years, 1% can mean a difference of hundreds of thousands of dollars. 

Considerations for Evaluating Expense Ratios

Investors may potentially need to make a trade-off between expense ratio and portfolio performance. Some funds with a higher expense ratio also have higher average returns. In that case, especially if you’re far from retirement and willing to take on additional risk, the higher expense ratio could be justified. 

You may want to analyze expense ratios relative to the fund’s investment strategy and objectives. The potential impact of asset size on expense ratios is significant. Funds with a smaller level of AUM may have higher expense ratios. Consider also the fund’s investment objectives, assets, the range of services it offers, fees that investors pay directly and whether the fund is a load or no-load fund to accurately compare expense ratios between different funds.

Tips for Minimizing the Impact of Expense Ratios

Investors looking to minimize the impact of expense ratios can consider low-cost index funds or exchange-traded funds( ETFs). However, conducting thorough research and due diligence is important. Evaluating the fund management’s ability and track record to justify higher expense ratios.

Why Expense Ratios Matter 

Expense ratios can have a long-term impact on wealth-building and income generation. Whenever you invest, look at expense ratios, management and historical returns and balance those with your investment goals, risk tolerance and long-term financial targets.  

Frequently Asked Questions