An expense ratio is the fee that mutual funds and exchange traded funds (ETFs) charge investors to offset the cost to run the fund. These operating expenses are expressed as a percentage of the fund’s assets under management (AUM). For example, a mutual fund might have a 1.25% expense ratio.
The majority of the expense ratio is paid to the investment manager, but other operating expenses include costs such as shareholder recordkeeping, administration, distribution, legal services, marketing and shareholder services.
Operating expenses can differ significantly from one fund to another depending on the amount of assets in the fund as well as the investment strategy. Some strategies, such as an international fund, may have higher expense ratios because the cost associated with researching and investing internationally is greater.
In general, ETFs have lower fees than actively managed mutual funds because ETFs typically invest in an index, rather than having an investment manager select the stocks or bonds. As a result, on an asset-weighted basis, Morningstar found that in 2015, the average expense ratio for all passive funds was 0.18% compared to 0.78% for actively managed funds.
Jemma Everyday Wisdom: Since expense ratios vary significantly depending on the investment strategy, it’s important to understand fees when choosing a mutual fund or an ETF.