Expense ratios: What they are and why they matter

What is an expense ratio?

An expense ratio reflects how much a mutual fund or an ETF pays for portfolio management, administration, marketing, and distribution, among other expenses.

The cost is taken out of the fund's returns before they're passed on to investors. You'll almost always see it expressed as a percentage of the fund's average net assets (instead of a flat dollar amount).

You can find a fund's expense ratio in its prospectus. Expense ratios will vary based on the product and the brokerage you use.

What's a net expense ratio?

While the gross expense ratio shows you how much a fund costs, the net expense ratio—also known as the total expense ratio—shows you what you'll pay. It considers any fee waivers or reimbursements that the fund manager may offer. A lower net expense ratio can mean higher returns over time.

For example, a fund might have a gross expense ratio of 1.2%, but if the fund manager waives 0.3% of the fees, the net expense ratio would be 0.9%. Fee waivers and reimbursements can change, so be sure to watch for any updates from the fund manager. Also, keep in mind that while a fee waiver and its expected termination date will be disclosed when you buy, you may not get notified when the waiver ends.

Types of funds and expense ratios

ETFs and mutual funds are similar. They both can spread your investments across a broad range of asset classes, sectors, and geographies. They're also professionally managed. But their expense ratios—and, in turn, the returns you get to keep—can vary.

Passive vs. active management

The way mutual funds and ETFs are managed can affect their expense ratios. Actively managed ETFs or mutual funds are run by portfolio managers who aim to outperform the market by selecting specific investments. They typically have higher expense ratios because of the additional costs associated with research and frequent trading. On the other hand, passively managed funds—known as index funds—aim to mirror the performance of a specific market index. They generally have lower expense ratios because they require less active management and trading.

ETF expense ratios

ETFs can be more cost-effective than mutual funds because of the way they trade. When ETF shares are sold, they're exchanged between buyers and sellers on the market instead of with the fund company. Since the fund doesn't have to buy or sell securities to create or redeem shares, operational expenses can be lower.

When do you pay expense ratios?

Expense ratios aren't paid separately. Instead, they're deducted directly from the fund's returns.

For example, if a fund's expense ratio is 1% and the fund generates a 10% return, the actual return you'd receive as an investor would be 9%. This deduction happens automatically—you won't receive a separate bill for these expenses. This means that the higher the expense ratio, the more of your potential returns are being used to cover the fund's costs.

Regardless of the fund's performance, the expense ratio remains a fixed cost.

How are expense ratios calculated?

An expense ratio is the total annual expenses of the fund divided by the fund's total net assets. For example, if a fund had total annual expenses of $1,000,000 and net assets of $100,000,000, the expense ratio would be 1%. If you invest $10,000 in this fund, you'll pay $100 in fees each year.

While this might seem like a small amount, it can add up over time—especially in a larger investment portfolio. It's important to understand and compare expense ratios when choosing funds. This can help ensure you don't pay more than you need to for management and operating costs.

How expense ratios affect long-term returns

While a small percentage might seem negligible, the cumulative effect over time can be substantial. For example, a fund with a 1% expense ratio will cost you $100 in the first year. But as your investment grows, the dollar amount will increase. Over time, this can amount to thousands in lost returns.

On the other hand, a lower expense ratio can make a substantial difference in your portfolio's growth over the long term. That's because more of your investment is working for you.

Two funds might have the same returns, but their costs could be vastly different. A fund with a higher expense ratio might appear more attractive due to its past performance, but the higher fees could negate similar gains in the future. Carefully comparing expense ratios can help you maximize your long-term returns and achieve your financial goals.

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While expense ratios may seem like small percentages, they can significantly affect how much of your investment returns you get to keep. That's why it's important to carefully compare the overall performance, cost, and management styles of different funds.