Investors readily acknowledge the fact that their returns will be diminished by trading commissions, account service fees, and (sometimes) taxes. Although these are typically perceived as the only costs, for the investors involved with mutual funds, unfortunately, they are not the only dents in profit. Returns from investments in index funds, mutual funds, and exchange-traded funds are deducted by administrative and operating expenses on an annual basis.
Of course, the cost of these expenses varies depending on the type of fund. But if we consider a specific fund, the expenses within that joint investment remain fairly steady. Therefore, the portion of costs within an investment is best described as a ratio, or in this case, an expense ratio.
So, what is an expense ratio?
The expense ratio (ER) of a fund illustrates the percentage of assets that are used to cover essential expenses (management and administration).
The formula for calculating this ratio is:
Total Fund Expenses / Total Fund Assets = Expense Ratio
In the formula above, “Total Fund Expenses” covers a whole host of expenses, and we will delve deeper into what that means below. But before we get into that, keep in mind that there is a particular way to estimate the “Total Fund Assets” part – and in finance, it’s known as “assets under management” (AUM).
AUM is used to express the total market value of all financial assets. In plain terms, this is the amount of money a fund manages on behalf of investors at any given time. Also, it is important to note that AUM refers to the fund viewed as a whole.
The expense ratio is expressed as a percentage of your investment that goes for these costs per annum. In terms of range, you can expect a value of 0.2% (or lower) for a passive fund, to 1.5% (or higher) for an actively managed fund. Don’t get fooled by the seemingly low expense ratio – the bigger the investment, the larger the portion of costs. For example, if you invest $1000 in a period of one whole year in a fund with an expense ratio of 0.48% – you will be charged $4.8. This can easily translate into bigger integers for large funds.
The actual resulting costs will become more clear as we get into the specifics of ER calculations.
How does expense ratio calculation work?
Although the ratio is calculated on an annual basis, the costs for funds are deducted daily. They are usually deducted from the total revenue of the mutual fund and then disbursed to the investors. This is important because these day-to-day deductions will not appear as a separate charge in reports sent to shareholders in the fund. That’s not to say they are somehow hidden or unavailable. Rather, they are incorporated in the figure for the daily net asset value (NAV) of shares in the fund.
Net asset value vs assets under management
NAV is used to describe the value of assets after all fees and expenses are paid. Compared to AUM, which expresses the total value of the fund, NAV makes it possible to calculate the value per each share once liabilities are settled. So, when a shareholder receives a performance update, they receive info on the value per share and the cost is already factored into the NAV.
The expense ratio is more relevant when investors decide whether to join a mutual fund because the percentage will provide an idea about what they can expect the long-term expenses on their returns to be.
What exactly is included as an expense?
Managing fees are the greatest expense in any fund, and we will explain why in this section. However, keep in mind that many other costs and fees factor in as well. There are some that aren’t even included in the expense ratio (like transaction costs and taxes), so don’t take this percentage as a be-all and end-all. Let’s take a closer look.
Expense ratios include administrative costs that are, strictly speaking, necessary to comply with regulations put forth by the Securities and Exchange Commission (SEC). This component covers custodial services, legal costs, accounting fees, registration fees, taxes, auditing, and similar types of fees.
This is a fee dedicated to advertising and promotion, as well as the printing and mailing of literature and prospectuses. It’s named after the SEC’s provision for distribution costs and is limited to 1% of the total value of the fund. The 12B-1 fee also covers shareholder servicing, i.e. services such as fulfilling investor inquiries and updates on the performance of investments.
Obviously, this is the portion of the fees that goes directly to a fund manager. They are higher for actively managed mutual funds and are a form of reimbursement for the time, effort, and expertise invested in managing a portfolio. In specific terms, this is for the labor required to select and then trade investments, to ensure proper balancing of the portfolio, to process distributions, and to complete other tasks along those lines.
Finding the expense ratio of a mutual fund
Each fund has an obligation (before the SEC) to make the expense ratio publicly available in their prospectus. The Financial Industry Regulatory Authority (FINRA) goes a step further in providing help to investors when choosing funds. Investors can use the FINRA fund analyzer to compare different products instead of checking the data in each individual prospectus.
But even with all those resources, potential investors would still benefit from reading the fine print on these offers. One of the items that can make a difference is the relationship between gross and net expense ratios.
Gross expense ratio vs net expense ratio
This relation becomes relevant if an investor is offered a discount or a waiver of some of the fees upon joining a fund. As with similar financial (or accounting) terminology, the gross value doesn’t take into account waived fees, while the net value is calculated after covering these fees.
Sometimes, the net expense ratio is listed, and in this case, investors have the actual cost including the discounts. On the other hand, the gross expense ratio expresses the regular costs which investors would pay if they don’t take advantage of the (usually limited) offer.
Expense ratios vary for different funds
A lot of factors influence the expense ratio for a given fund. However, certain aspects of the structure of these funds can serve as general guidelines for new investors. For example, it is postulated that the size of a mutual fund has an inverse relationship to the expense ratio. Big funds need to reserve a small portion of their total asset value for expenses, while small funds are faced with relocating what little available resources they have for expenses.
Past activity and maturity of the fund are another factor that has an effect on the expense ratio. Funds with established track records can influence expense ratios either way. For example, a fund that has been engaged in investment management for years might have a relatively low expense ratio. At the same time, fund managers with a good reputation, or those that engage in leveraged trading, can drive expense ratios for funds they control to unreasonably high levels.
ER for index funds vs ER for actively managed funds
Management fees are the most prominent component of the costs covered by expense ratios, so, quite naturally, actively managed portfolios attract higher ratios. This doesn’t mean that passively managed funds totally exclude investment management costs. A lot of work goes into setting up an index fund, even if it’s simply attached to one of the popular indices (Dow Jones, S&P 500, etc.). However, relative to active day-to-day management, these expenses are low.
Also, active management sometimes includes a team of researchers and analysts looking for opportunities, and this results in high ER. Let’s take a look at the optimal expense ratios per type of fund.
There are passively managed index funds that have no expense ratio, like Fidelity ZERO Large Cap Index (FNILX). Yes, this means that they don’t charge expense fees. Apart from that, an expense ratio of 0.02% is considered low for index funds. A typical example of this is Schwab S&P 500 Index (SWPPX).
The lowest expense ratio for actively managed mutual funds is 0.52% for Dodge & Cox (DODGX). Although the typical ER is somewhere between 0.5% and 1.0%, there are funds with higher ER (up to 2.5%), but they are definitely not recommended.
Exchange-traded funds (ETF)
Since ETFs can be attached to indices, they also have a low expense ratio – starting from 0.03%. Although an ER of up to 1.0% is reasonable, do note that a recent study found that the downturn trend of expense ratios for ETFs is likely to continue.
What costs are not included in an expense ratio?
As much as we’d all prefer it if expense ratios were a measure of total expenses associated with an investment in a mutual fund, this is not the case. There are a number of fees that depend on specific activities or apply to particular types of funds, but not to others. Also, some fees apply only once and can not be included in a percentage that is calculated on an annual basis. So investors must not forget to check these figures as well.
These are management fees that apply to actively managed mutual funds but are not considered expenses, so they are excluded from the expense ratio. They are also known as operating fees and include costs for recruiting advisors to the team of fund managers. Also, this fee can include any other operational costs that are not covered by the other category as long as they are in line with SEC directions.
No one can know the transaction costs in advance because they depend upon the trading activity. They include trading fees or brokerage costs such as purchase fees, contingent deferred sales charges (CDSC), redemption fees, exchange fees, account fees. etc. Some mutual fund managers charge a front-end load (a one-time fee paid when the shares are bought). And on the back end, exit loads as high as 2% are charged to discourage investors from redeeming their assets before the time frame that has been agreed upon.
Again, this cost depends on the type of assets being managed in the fund. For example, if the mutual fund holds dividend stock that is distributed to investors, tax is due for these returns.
The numbers can quickly add up
Investors should also bear in mind that even though the expense ratio is calculated annually, the amount that dents their returns actually has some far-reaching implications in the long run. We are referring to the elusive losses in the form of compound interest. The annual charge erodes the base used to calculate the compound on overall gains. If the assets are considerable (into the hundreds of thousands), over a couple of decades, this translates into losses that can amount to tens of thousands of dollars.
Final tips on choosing a good ER
Generally speaking, there are two recommendations on choosing an investment fund with the right expense ratio: shop around and take a comprehensive approach.
These days, there are more than enough resources to research different products before you choose the right fund for you. Yes, you can use the favorable expense ratio range for a certain type of fund as a benchmark, but if you have some time on your hands, you can always find a better offer. In terms of index funds, for example, that would be an offer without an expense ratio.
Then, also beware that investment in a fund should not be judged solely on the criterion of expense ratios. This is such a complex decision that you simply must factor in other aspects as well. You need to take your goals into account, the assets you are willing to lose on taxes and brokerage fees, the amount of trading for the given fund, its overall time horizon, and so forth.
The expense ratio is only one element you need to take into account before making the final decision.