What is expense ratio in ETFs?

The expense ratio is one of the most vital aspects of ETF investing. However, many investors are unaware of the fact that a portion of your portfolio is allocated to a charge termed an expense ratio each year.

It’s critical to understand the costs you’re paying no matter what you’re investing in. 

And, given the prevalence of mutual funds and exchange-traded funds (ETFs), many of us pay an annual expense ratio out of our portfolios. You’ll learn what an expense ratio is, why it’s essential, and how to spot a good one when you see one.

What is an Expense ratio?

An expense ratio is a fee that a mutual fund or exchange-traded fund charges investors (ETF). This charge covers the costs of management, asset allocation, marketing, and other services.  

These fees calculation are done as a percentage of an investor’s annual cost. ETF expense rates are usually less than 1%. That means you spend less than $10 per year on expenses for every $1,000 you invest. 

“In the simplest terms, an expense ratio is a convenience fee for not having to pick and trade individual stocks yourself”. 

– Leighann Miko, certified financial planner (CFP) and founder of Equal Financial, explains expense ratio

The expense ratio is the reward for the fund managers for supervising the fund’s holdings and coordinating investment plans in actively managed funds.  

Activities of the fund manager include time spent choosing and trading securities, reallocating the portfolio, processing payouts, and other procedures necessary to keep the fund up to meet its objectives. 

The expense ratio encompasses license fees paid to significant stock indices for passive funds and ETFs that don’t actively select investments and instead try to replicate the underlying index. 

Calculation of expense ratio 

Expense ratio = Total fund expenses / Total fund assets under management

How do they work? 

The expense ratio is expressed as a percentage of your fund investment. A fund, for example, might charge 0.30 percent. That implies for every $1,000 you put into the fund; you’ll pay $3 per year.  

If you own the investment for the entire year, you’ll have to pay this. However, don’t think you’ll be able to sell your funds right before the end of the year and escape paying the fee.  

The management company for an ETF will deduct the cost from the fund’s net asset value daily, making it essentially undetectable to you. 

What does a reasonable expense ratio look like? 

According to experts, an expense ratio of < 2% is low and > 2% is considered high. The higher your expense ratio, the lower your returns will be. 

As per Morningstar, the weighted mean expense ratio for ETFs in 2019 was 0.45 percent. That’s less than 1/2 from what it was in 1999, and the trend is anticipated to continue.

It’s a matter of opinion on what defines a decent expense ratio for an ETF. Investors aren’t liable to pay hefty prices to invest in ETFs, and they should focus on ETFs with competitive and consistent expense ratios. 

What else should you think when it comes to the expense ratio? 

Experts advise looking for reduced-cost funds so you don’t lose a lot of money in fees throughout your mutual fund investment duration.

It’s not only the upfront costs; you’re also losing the value of those assets as they compound. 

• Larger funds can frequently carry a lesser expense ratio because some expenditures, such as fund management, can spread over a more extensive asset base. 
• The smaller fund may need to charge more to break even, but as it expands, it may be able to lower its expense ratio to a comparable price. 

Mutual funds may levy a sales load, which can be pretty high (up to a few percent) but is taken into account for the expense ratio.

That’s a different type of cost, and you must do everything you can to avoid funds that charge them. Major brokers provide many mutual funds with no sales load and low expense ratios.