fbpx

What is the Expense Ratio?

Expense Ratio

Share This...

Expense Ratio

The expense ratio is a measure used most commonly in the investing industry to show the percentage of a fund’s assets that are used for administrative and other operating expenses. In simpler terms, it’s a measure of what it costs an investment company to operate a mutual fund, index fund, or exchange-traded fund (ETF).

The expense ratio is calculated by dividing a fund’s operating expenses by the average dollar value of its assets under management (AUM). It is often expressed as a percentage. For example, if a fund has $100 million in assets and $1 million in operating expenses, its expense ratio is 1.0% ($1 million / $100 million).

The types of costs covered by the expense ratio can include:

  • Administrative costs: Record keeping, customer service, etc.
  • Management fees: Fees paid to the fund’s managers for their services.
  • 12b-1 fees: Fees used to cover a fund’s marketing and distribution costs.

Expense ratios are important to investors because they directly reduce the fund’s returns to the investor. For example, if a fund earns a 7% return for the year and has an expense ratio of 1.0%, then the investor’s net return would be 6.0%. Therefore, all else being equal, a lower expense ratio is generally better for investors.

Example of the Expense Ratio

Let’s consider an example using two fictional mutual funds.

Mutual Fund A:

  • Total Assets Under Management (AUM): $500 million
  • Total Operating Expenses: $2.5 million

To calculate the expense ratio, we would divide the total operating expenses by the total assets, and then multiply by 100 to convert it to a percentage:

Expense Ratio A = ($2.5 million / $500 million) x 100 = 0.5%

Mutual Fund B:

  • Total Assets Under Management (AUM): $200 million
  • Total Operating Expenses: $2 million

Using the same calculation:

Expense Ratio B = ($2 million / $200 million) x 100 = 1.0%

This means that for every dollar you invest in Mutual Fund A, 0.5% is used for operating expenses, whereas for Mutual Fund B, 1.0% is used for operating expenses.

If you were deciding between investing in these two funds and they were identical in every other way, you would likely choose Mutual Fund A because its lower expense ratio means a greater portion of your investment would be working for you, rather than going towards operating expenses. This difference becomes more significant over time due to the compounding effect.

Other Posts You'll Like...

Want to Pass as Fast as Possible?

(and avoid failing sections?)

Watch one of our free "Study Hacks" trainings for a free walkthrough of the SuperfastCPA study methods that have helped so many candidates pass their sections faster and avoid failing scores...