What is Expense Ratio in ETF?

Frank Sinatra sang that the best things in life are free, and the investment industry is slowly starting to come around to that wisdom. Most major brokers have eliminated commissions on basic investments, and the fees charged by funds and asset managers have been steadily moving lower. 

However, investors still have to consider costs when building their portfolios, and one of the most crucial to contend with is the expense ratio in exchange-traded funds (ETFs). Expense rates vary from fund to fund, but in this article, Benzinga reviews how they’re calculated, what investors get for their money and how to avoid allowing fees to eat into returns.

How Does Expense Ratio Work?

An ETF expense ratio is the price of membership into the fund. Some funds have costs like load fees, early redemptions and other transaction costs, but the expense ratio is an ongoing charge that is automatically deducted from an investor’s capital. Most expense ratios are listed as a percentage, such as 0.08% of assets. A 0.08% expense ratio means an investor will pay $8 for every $10,000 of capital invested in the fund annually.

Mutual fund and ETF shares carry expense rates covering the fund's basic operating expenses. This fee is prorated daily, so investors pay a small fraction each day they remain invested. Many low-cost index funds from Fidelity and Schwab have driven these expense ratios nearly to zero, much to the benefit of buy-and-hold retirement savers who aren’t looking for outsized returns.

Components of Expense Ratio

What goes into an expense rate? Here are the three most common costs built into running a fund.

• Management fee/advisory fee: All ETFs have an advisory team to pay, whether it's portfolio managers picking stocks or deciding which market index to track. Paying managers is usually the most significant component of an ETF expense ratio, which is why there’s so much variation from fund to fund.

• Administrative costs: Asset managers don’t construct ETFs out of the kindness of their hearts. Funds are businesses that incur various day-to-day operating expenses beyond management fees. These costs include sending prospectuses and monthly statements, customer service, office supplies, data security and other ordinary business expenses.

• Other miscellaneous expenses: ETFs occasionally have additional costs not associated with administration tacked onto the expense ratio, such as advertising and promotional spending. 

How to Calculate Expense Ratio

An expense ratio doesn’t require a complicated formula. Since expense ratios are termed as a percentage of assets, the equation is the following:

Cost of operating the fund / Total assets under management

Here’s a less vague example. Imagine it costs $450,000 annually to operate a fund with $300 million in assets. Divide 450,000 by 300,000,000, and you’ll get 0.0015. Now multiply that by 100, and you’ll get 0.15, meaning this fund carries a 0.15% expense ratio. At 0.15%, investors are paying $15 each year for every $10,000 worth of ETF shares they hold.

Significance of Expense Ratios in ETFs

Investors have few things they can control when it comes to markets. Inflation, geopolitical issues, economic sentiment, corporate earnings — all these factors influence market returns and investors have no authority over any of them. However, one thing investors can control is the price they pay for the privilege to invest, and for those with long-term goals, much of this cost comes from an ETF expense ratio.

One way to think of an expense ratio is like an additional tax on your gains, but you get to choose the rate you pay. Particular investment or management styles will naturally have higher expense ratios than others. For example, active vs. passive is one of the more dynamic debate topics among investors. Active fund managers attempt to beat market benchmarks, while passive funds track a market index like the S&P 500 or NASDAQ 100. On average, active funds are more expensive to own than passive ones. But active managers are trying to beat the market, while index funds just want to match it. 

Which style better suits your investment goals? Many studies have shown that active managers fail to consistently beat the market over time, which is why long-term retirement savers usually prefer index funds. But if you have a more aggressive mindset and a shorter time horizon, certain active strategies may be more attractive. Ensure you understand the fund’s goals and investment thesis before paying a hefty expense rate.

Considerations When Analyzing Expense Ratios

Asset allocation decisions go deeper than just comparing the market price of various ETFs. Here are three crucial considerations about expense ratios for investors to consider.

Balancing Cost and Value

Expense ratios rise depending on the objectives and investments of the fund. Even similarly styled funds can have wildly different expense rates. For example, investors can buy index funds that track broad indices like the S&P 500, smaller ones like the Russell 2000 or downright obscure ones like the USA Momentum SR Variant Index. As the scope of asset allocation narrows, the cost of managing the fund rises, as does the possibility of tracking errors. Investors must balance the price they pay versus the value a fund offers.

Impact of Expense Ratios on Long-Term Investment Strategies

Expense ratios are deducted from returns, which means there’s a long-term drag on compounding. A 0.15% expense rate may not sound expensive, but that’s $15 out of every $10,000 gone yearly. Over time, paying high expense rates can seriously dent long-term returns. If you save $10,000 annually for 30 years in a fund with a 0.15% expense rate, you’ll pay nearly $23,000 in fees over that timeframe. That’s $23,000 that didn’t enjoy the benefit of being reinvested, a significant opportunity cost.

Identifying Reasonable Expense Ratios Based on Fund Type and Objective

Investors shouldn’t compare ETF expense ratios in a vacuum. If you want to invest in a specific market sector like tech or financials, you should expect to pay more for an ETF than a similar size fund that tracks the S&P 500. Sort ETFs based on their goals, holdings, and size and group matching funds together, then compare rates.

Factors Influencing Expense Ratios

What’s a fair expense ratio to pay for holding a fund? Here are some of the factors that influence the rate asset managers charge for their funds.

Asset Size and Economies of Scale

Bigger isn’t always better when investing, but for ETFs, more assets usually means cheaper overall costs. With a more extensive asset base to pull from, funds can lower the fee paid by each investor.

Fund Strategy and Complexity

The broader the strategy, the more efficiently the fund will handle costs. For example, an index fund tracking the S&P 500 won’t require much due diligence. But a fund that invests in small-cap tech stocks will need substantially more investment research, which adds to the expense rate.

Active vs. Passive Management

The debate continues perpetually, but actively managed funds will almost always have higher expenses than passive funds of similar asset classes or strategies.

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The expense ratio is the percentage of assets investors pay to own a mutual fund or ETF. While expense rates are often tiny on an annual basis, high expense rates can significantly reduce returns over time. Lower is almost always better when it comes to ETF expense ratios, so if you want to invest in higher-rate funds, make sure you can justify your decision. 

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