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Expense ratio explained: Why even a small difference matters
Pricing
Key takeaways:
- An expense ratio is the annual fee a mutual fund or ETF charges to cover operating costs, expressed as a percentage of the fund’s average net assets.
- Expense ratios are usually deducted through the fund’s net asset value, so they may not appear as a separate bill but still reduce net returns over time.
- Expense ratios vary by fund category, with actively managed mutual funds often costing more than broad passive ETFs, while sector-specific or niche funds may also carry higher fees.
- Assessing whether an expense ratio is competitive means comparing similar funds by category, strategy, risk, performance after fees and any additional charges.
- Even small expense ratio differences can compound over long periods, leaving more or less of a fund’s gross return available to the investor depending on costs and assumptions.
Investment costs can affect long-term returns, but not all costs are obvious at first glance. Expense ratios, which may look like a small percentage, reduce the fund returns investors receive after costs.
Knowing how expense ratios work can support comparisons between similar funds, especially when reviewing costs alongside risk, strategy and performance after fees. Over time, even minor differences in these fees can compound and significantly affect your portfolio's performance.
What is an expense ratio?
An expense ratio represents the annual fee a mutual fund or ETF charges investors to cover operating costs. It is expressed as a percentage of the fund's average net assets. This seemingly small percentage can significantly impact your returns over time, making it useful to understand what it includes and how it is calculated.
The expense ratio encompasses various costs required to manage and operate the fund, including:
- Management fees. Compensation for portfolio managers overseeing the fund.
- Administrative costs. Accounting, recordkeeping, and other operational expenses.
- Legal and compliance fees. Costs related to regulatory adherence and fund governance.
- Marketing and distribution. For some funds, this includes distribution-related fees, such as 12b-1 fees in the US.
How expense ratios work
Expense ratios are automatically deducted from a fund's net asset value (NAV), covering operational costs without requiring separate charges.
These deductions are built into the daily NAV calculation, so the costs remain invisible to investors but reduce the fund’s net return over time. While seamless, this ongoing fee has a meaningful long-term impact on portfolio performance, depending on the size of the fee difference, return assumptions and holding period.
Funds may report two types of expense ratios:
- Gross expense ratio. Includes all costs without accounting for fee waivers or reimbursements.
- Net expense ratio. Accounts for any waivers or reimbursements, reflecting the actual costs paid by investors.
For example, a fund with a gross expense ratio of 1% but offering a fee waiver of 0.2% would report a net expense ratio of 0.8%.
How is the expense ratio calculated?
The expense ratio is determined using the following formula:
Expense ratio (%) = (Total operating expenses ÷ Total fund assets) × 100
For example, if a fund's operating expenses amount to USD 50,000 and the total assets in the fund are USD 10,000,000, the expense ratio would be:
(USD 50,000 ÷ USD 10,000,000) × 100 = 0.5%
A 0.5% expense ratio would represent about USD 50 per year for every USD 10,000 invested, assuming the investment value stayed constant.
Example:
Let's say you invest USD 20,000 in an ETF with a 0.3% expense ratio. Over the course of a year, you would pay:
USD 20,000 × 0.003 = USD 60
This cost is reflected in the fund’s net asset value rather than usually appearing as a separate bill.
It's vital to understand the expense to assess a fund's cost-effectiveness and compare it to other investment options. Even slight differences in these fees can add up significantly over time.
Types of expense ratios across fund categories
Expense ratios vary based on the type of fund, reflecting differences in management approach, investment strategies, and operational requirements.
Mutual funds
Actively managed mutual funds typically have higher expense ratios. These costs arise from professional managers who analyse data, research opportunities, and adjust portfolios with the aim of outperforming market benchmarks.
As a result, expense ratios for mutual funds can vary widely and are often higher for actively managed funds than for broad passive funds.
Exchange-Traded Funds (ETFs)
ETFs generally have lower expense ratios, with most adopting a passive management approach. Designed to track an index such as the S&P 500 or MSCI Emerging Markets Index, ETFs incur fewer management costs. Expense ratios for ETFs are often lower than those of actively managed mutual funds, although they vary by provider, market, asset class and strategy.
For example, a broad-market ETF charging 0.03% may offer relatively low-cost exposure compared with higher-fee alternatives, although investors should also consider tracking error, liquidity, currency exposure and product structure.
Sector-specific or niche funds
Funds focused on specific sectors or themes, such as technology, renewable energy, or emerging markets, can often have higher expense ratios. The added complexity of managing these funds involves specialised research and unique market risks.
Expense ratios for these funds may range from 0.5% to 1.5% for actively managed options and from 0.1% to 0.5% for passive sector ETFs.
How to assess whether an expense ratio is competitive
Expense ratios vary depending on the type of fund, but category comparisons can help investors assess whether a ratio is high or low relative to similar funds:
- Index funds. May be considered relatively low cost when their expense ratios are low compared with similar funds tracking the same or similar indices.
- Actively managed funds. Often carry higher expense ratios, so investors usually compare costs against strategy, risk, performance after fees and similar alternatives.
To determine if an expense ratio is "good," compare it with similar funds in the same category. For example:
- An S&P 500 index fund with an expense ratio of 0.1% is competitive.
- An actively managed equity fund with a higher ratio would need to be assessed against its strategy, risk profile and performance after fees relative to comparable funds.
High expense ratios deserve closer review, especially where the fund does not clearly explain the costs, strategy or potential trade-offs.
How expense ratios impact long-term returns (example)
Even a small difference in expense ratios can lead to significant disparities in portfolio performance over time due to compounding. Here's an example:
Consider two investors, each starting with USD 100,000 and earning a 7% annual return before fees:
- Investor A chooses a fund with a 1% expense ratio.
- Investor B opts for a fund with a 0.2% expense ratio.
After 20 years and considering the compounding effect:
- Investor A’s portfolio grows to approximately USD 320,713, about USD 66,255 less than a simplified no-fee scenario using the same gross-return assumption.
- Investor B's portfolio grows to approximately USD 372,756, about USD 52,043 more than Investor A in this example.
Note: This simplified example assumes a constant 7% annual return before fees, no contributions or withdrawals, no taxes, no trading costs and unchanged expense ratios.
Fees are subtracted from your returns every year, reducing the amount available for reinvestment. Over decades, this compounds into a substantial difference in final portfolio value. Lower expense ratios leave more of the fund’s gross return available to the investor, all else equal.
How to assess and reduce the impact of expense ratios
Reducing the effect of expense ratios can help reduce the drag of costs on long-term returns. Minor cost differences can compound into significant sums over time, making it essential to consider the following factors:
Compare funds with lower expense ratios
Lower-cost funds leave less of the fund’s gross return deducted as fees, although cost should be reviewed alongside risk, strategy and suitability. Broad index funds and ETFs often have lower expense ratios than many actively managed funds, although this varies by product and market.
Check for sales loads, redemption fees and other additional charges
Sales loads, redemption fees, and other hidden charges reduce your capital and returns. No-load funds may reduce certain upfront or distribution-related costs, depending on the product and platform. Many platforms now highlight these low-cost options, making them easier to identify.
Compare expense ratios across similar funds
Use fund screeners and calculators to evaluate expense ratios within the same category. For example, compare multiple S&P 500 index funds to find the one with the lowest cost while offering similar performance. Fund screeners and platform tools, including those offered by Saxo, can support this comparison.
Pay attention to fund size and scale
Larger funds often benefit from economies of scale, allowing them to charge lower expense ratios, although size alone does not determine cost, liquidity or suitability. These savings come from spreading operational costs across a greater pool of assets. While smaller funds may target higher returns, they often carry higher costs due to their limited asset base.
Assess the trade-off between cost and performance
Evaluate whether a fund's expense ratio aligns with its potential to deliver returns. A higher-cost, actively managed fund may be considered differently if its performance after fees, risk and strategy compare favourably with alternatives, although this is not guaranteed. However, only a small fraction of actively managed funds achieve this over the long term, so proceed cautiously.
Conclusion: Expense ratios shouldn't be overlooked
At first, expense ratios might not seem like a big deal, but over time, these small percentages can reduce net returns, so understanding and managing them is important.
Choosing funds with low expense ratios—like index funds and ETFs—means less of the fund’s gross return is deducted as fees, considering everything else stays the same. Thanks to compounding, even a tiny difference in costs can add up over decades. That's why comparing funds (and avoiding extra fees) is so important.
Remember that, all else equal, lower fees leave more of the fund’s gross return available to the investor. Taking the time to evaluate expense ratios now may make a meaningful difference to long-term net returns, depending on performance, holding period and other costs.