Expense Ratio: Definition, Formula, Components, and Example

What Is an Expense Ratio?

The expense ratio is how much you pay a mutual fund or ETF per year, expressed as a percent of your investments. So, if you have $5,000 invested in an ETF with an expense ratio of .04%, you'll pay the fund $2 annually.

An expense ratio is determined by dividing a fund's operating expenses by its net assets. Operating expenses reduce the fund's assets, thereby reducing the return to investors because the expense ratio is deducted from the fund's gross return and paid to the fund manager.

Calculating the Expense Ratio

It's very rare to need to calculate a fund's expense ratio, as it is required to state it in its prospectus. Additionally, because it is an important metric for investors, expense ratios are almost always found on a fund's website. But if you need to calculate it, this is the formula:

$\begin{aligned} &\text{ER} = \frac{ \text{Total Fund Costs} }{ \text{Total Fund Assets} } \\ \end{aligned}$​ER=Total Fund AssetsTotal Fund Costs​​

Where:

• Total Fund Costs: The total of all management, transfer agent, accounting, custodian, trustee, auditing, legal, interest, miscellaneous, and other relevant operating fees (does not include loads or commissions)
• Total Fund Assets: The fund's net assets

You'll need to locate the fund's operating expenses in its financial statements and net assets on its webpage (or financial statements).

Components of an Expense Ratio

Most expenses within a fund are variable; however, the variable expenses are fixed within the fund because of how it is calculated. For example, a fee consuming 0.5% of the fund's assets will always consume 0.5% regardless of how it varies.

In addition to the management fees associated with a fund, some funds have an advertising and promotion expense referred to as a 12b-1 fee, which is included in operating expenses. Notably, 12b-1 fees within a fund cannot exceed 1% (0.75% allocated to distribution and 0.25% allocated to shareholder servicing) according to FINRA rules.

A fund's trading activity—the buying and selling of portfolio securities—is not included in the calculation of the expense ratio. Costs not included in operating expenses are loads, contingent deferred sales charges (CDSC), and redemption fees, which, if applicable, are paid directly by fund investors.

Expense Ratios of Passive vs. Active Funds

The expense ratios of passively managed funds and actively managed funds depend on how they are structured and managed:

• Many ETFs and mutual funds are passively managed funds that track an index, which allows them to have very low fees.
• There are several actively managed mutual funds and ETFs that have higher expense ratios due to their goals and strategies.
• Many active and passive funds use asset-weighted strategies, which means they hold more assets from specific issuers or sectors than others based on a value comparison—leading to higher expense ratios than funds that don't use asset-weighting.

The Vanguard S&P 500 ETF (VOO), a passively managed index fund that replicates the Standard & Poor's (S&P) 500 Index, has one of the lowest expense ratios in the industry at 0.03% annually. This fund does not use asset-weighting, but the Vanguard Consumer Staples ETF (VDC) does—and it has a much higher 0.10% expense ratio. VDC mimics the MSCI US IMI Consumer Staples 25/50 index but weighs three sectors differently than the index.

The Fidelity Contrafund (FCNTX) is one of the largest actively managed funds in the marketplace, with an expense ratio of 0.39%, or $39 per $10,000 invested. This fund is much more highly weighted toward communication services than its benchmark, the S&P 500.

The Bottom Line

Expense ratios are taken from mutual fund and ETF returns to help pay for operations and fund management. The expense ratio charged to investors will vary depending on the fund's investment strategy and level of trading activity. In general, expense ratios have declined steadily as competition for investor dollars has heightened.

Actively managed funds and those in less liquid asset classes tend to have higher expense ratios, while passively managed index funds feature the lowest expense ratios.