# What is the Expense Ratio?

## 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.