In mutual funds and banking, the expense ratio is a fee that is collected/charged as a percentage value of the fund’s overall assets. Expense ratios are deductions made from the gross returns of a fund which in turn reduce the investors’ returns. Thus, the expense ratio can be referred to as the fee charged for the maintenance of an investment portfolio.
Ranging from the reimbursement or wavering agreements to fund size variations, let us understand expense ratios in detail along with their key components and their calculative formula.
Expense Ratio (ER): Key Takeaways
- Expense ratios are highly significant to investors in prompting investment decisions since they have a notable impact on the ROI (return on investments).
- The expense ratio is a fee charged by Exchange Traded Funds (ETF) and mutual funds as a percentage of the total assets for the maintenance of the funds or the investment portfolio.
- Expense ratios are also popular as gross expense ratios, net expense ratios, and after-reimbursement expense ratios.
- However, there is a decline in expense ratios with the growth of investor dollars.
Expense Ratio: Definition and Meaning
An expense ratio is defined as the measure of how much the assets of a fund are utilized in the operating and administrative expenses. It is referred to as a percentage value found by taking a ratio between total costs and total assets associated with an exchange traded fund (ETF) or a mutual fund. It is an important component of the Finanical ratios and a parameter to determine the financial health of a company.
In mutual funds, it is the measure of operating costs calculated relative to the assets. It is the expense or fee charged annually by mutual funds and other exchange traded funds (ETF) companies. It incorporates all the costs of management, operations, advertising and charges of allocation.
Furthermore, the expense ratios with a lower value are generally more beneficial. However, higher expense ratios are justifiable if they lead to higher returns. Here is a list of some other important things to know about expense ratios.
Expense ratios show a variance based on fund size
Along with fund type, fund size also impacts expense ratios. A higher expense ratio is seen in funds that have smaller pools of assets as they have a relatively higher management cost when compared to funds with larger pools of assets.
Expense ratios vary by fund’s management style: Actively Managed Funds Vs. Passively Managed Funds
Based on the management style of a fund, expense ratios may vary. There is a significant variance in the expense ratios of actively managed funds and passively managed funds.
The expense ratio of an actively managed fund may range from 0.5% to 0.75% and anything above 1.5% is considered too high. On the other hand, the expense fees of a passively managed fund are generally lower.
Several exchange traded funds (ETF) and mutual funds are passively managed. They track an index that facilitates having lower fees. On the other hand, mutual funds and ETFs that are actively managed have a high expense fee because of their strategies and goals.
Further, many passively and actively managed funds utilize asset-weighted strategies that cause higher expense ratios in comparison to funds that do not utilize asset-weighting. In asset-weighted strategies, funds hold back more assets from particular sectors or issuers when compared to others as per a value comparison.
Expense ratios vary by fund type
Index funds and other passively managed funds have comparatively lower expense ratios since they do not require excess research, or selling and buying. Conversely, actively managed funds have higher expense ratios since they require considerable research, and selling and buying.
Expense ratios reduce ROI
Expense ratios significantly impact the returns on investment (ROI). A very high expense ratio would mean that a larger part of the returns on the fund are taken away as fund management fees. This implies a low ROI for investors.
Key Examples to understand Expense Ratio
Let us understand expense ratio by some examples:
- The expense ratio is expressed as a percentage of the investment value. Suppose an investor invests a value of $5000 in an exchange traded fund (ETF) that charges an expense ratio of 0.04% for the maintenance of the fund. The fund value to be paid as an expense fee annually would be $2 which is 0.04% of $5000.
- Now let us understand what it means when a mutual fund or ETF says that it will charge 0.75% as an annual expense ratio. This would mean that for every $1000 value invested in a year, an expense ratio of $7.50 would be cost. This value is the fee you’re paying a fund manager to manage your fund and let you access the strategies.
Vital Components of Expense Ratio
There are various components in the expense ratio of an exchange traded fund (ETF) or a mutual fund. These are as given below:
1. Management Costs or Fund Managers Fees
The management costs serve as a fee paid to investment and fund managers for their expertise in developing relevant and beneficial investment strategies. It normally ranges between 0.5% and 1% annually.
2. Administrative Fees
The administrative fees are charged to cover the operational expenses of the fund such as customer service, record keeping, etc.
3. Marketing and Distribution Expenses
The distribution fees are charged as compensation for the advertisement and promotion of the fund to investors.
4. Audit and Legit Costs
Expense ratios also incorporate the costs of auditing and legit. Besides these, there can be other operational costs included in the expense ratio.
The Formula of Expense Ratio for Calculation
There seldom arises a need to calculate the expense ratio. It is generally provided as a rule on the prospectus of the fund expenses and can be easily accessed on financial websites and company websites because of its significant importance to investors. Still, one can make use of the given formula to calculate the expense ratio.
“Expense Ratio = Fund’s Total Costs / Fund’s Total Assets”
ER = TC / TA
Here:
- Fund’s Total Costs: The total costs of the funds can be accessed in the financial statements and incorporate all the expenses of accounting, financial management, trustee, custodian, legal, auditing, transfer agent, interest and miscellaneous. Further, it includes the relevant operating expenses that do not include the commissions or loads.
- Fund’s Total Assets: The total assets of the fund can be accessed from the financial statement or the webpage and it refers to the net assets of the fund.
What is the Expense Ratio in Banking?
The expense ratio refers to the cost of owning an ETF or mutual fund. It is the value taken from ETF and mutual funds to finance operations and management of the fund. The expense ratio charged to an investor varies in accord with the fund size, fund type and the investment strategies of the fund.
An expense ratio is mostly associated with total net expenses though sometimes, investors go for gross expenses or net expenses.
What does the Expense Ratio mean in Mutual Funds?
The expense ratio in a mutual fund is the expense (fee) of maintenance charged upon investors by the concerned mutual funds. Generally, mutual funds have higher expense ratios than comparable exchange traded funds.
In return for the maintenance of the investment portfolio of an investor, and the management and operating costs involved in a fund, mutual funds charge an annual fee on investors. This fee is often expressed as a percentage value of the fund’s total assets.
The expense ratio in a mutual fund is very similar to how clients pay management fees to a fund company.
The expense ratio in mutual funds is calculated by dividing the total costs of the fund by the total assets. Among the various costs of the fund are management fees, legal fees, trading fees, and operational costs.
An investor’s profit is majorly affected by the expense ratio. It has a notable impact on decreasing the financial gains of an investor on an investment if the expense ratio associated with it is too high.
For instance, if there is a 5% return on investment (ROI) on a fund with an expense ratio of 2%, the actual return on investment (ROI) achieved by the investor would be 4%.
The margin to consider an expense ratio high or low is 1%. An expense ratio is considered generally high in mutual funds if the fund charges any value above 1% and low if the expense ratio’s value is below 1%. However, a higher value does not necessarily imply inadequate fund performance.
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Expense Ratio FAQs
Q1. What is an expense ratio?
Ans: An expense ratio is the percentage measure of the assets of a fund used for management purposes. Since it reduces the asset value, it reduces the ROI (Return on Investment) as well.
Q2. How do we calculate the expense ratio?
Ans: One can easily calculate the expense ratio by dividing the total costs of the fund by its total assets. Thus, expense ratio = net expenses / net assets.
Q3. Is expense ratio important for investors?
Ans: Yes. The expense ratio is important for mutual funds, ETFs, and particularly investors. This is because it significantly impacts the returns on invested assets. A lower expense ratio is better for investors as it means greater returns. However, if the fund's investment strategies promise higher returns then one may go with slightly higher expense ratios.
Q4. Can the Expense Ratio be zero?
Ans: Yes. The expense ratio for a fund can be zero. This means the fund does not charge any operational or management fee to the investor. Passively managed index funds and ETFs can have zero expense ratios because they do not incorporate much expense.
Q5. Where to find the expense ratio?
Ans: You can find the expense ratio on the website of the concerned company, listed in the prospectus along with all other expenses of the fund. It can also be found on several other financial websites.
