What Is an Expense Ratio?

What Is an Expense Ratio?

An expense ratio measures a fund's annual operating costs as a percentage of its average net assets. All mutual funds and exchange-traded funds (ETFs) are required by law to disclose their expense ratios in the fund's prospectus.

Because these costs are passed on to shareholders, the expense ratio directly reduces your investment's return. For example, a fund with a 0.50% expense ratio reduces your annual return by that amount before any other factors come into play.

Here's an overview of what an expense ratio covers:

What Does the Expense Ratio Include?

A fund's expense ratio is the sum of several cost categories. Most fund prospectuses break them down as follows:

• Management fees: Pays for portfolio manager salaries. Actively managed funds typically have higher management fees than passively managed index funds.
• Distribution or service, 12b-1: Covers marketing, advertising and certain shareholder services, and can run as high as 1% in some funds. Many ETFs do not charge a 12b-1 fee.
• Other expenses: A catch-all for remaining operating costs, including accounting, legal, custodial services and recordkeeping.
• Total annual fund operating expenses (expense ratio): The sum of all the above, expressed as a percentage of the fund's average net assets. This is the number to focus on when comparing funds.

What Does the Expense Ratio Not Include?

The expense ratio does not capture every cost associated with owning a fund. Some costs are charged directly to shareholders and fall outside the expense ratio, including:

• Certain shareholder fees: These are one-time charges for specific transactions, such as purchase fees, redemption fees or account maintenance fees. Not all funds charge these, but they can add to your overall cost when they apply.
• Trading costs inside the fund portfolio: When a fund buys or sells securities within its portfolio, it incurs transaction costs. These are not included in the expense ratio but can reduce overall returns, particularly for actively managed funds with high portfolio turnover.

Always review the full fee table in a fund's prospectus to get a complete picture of your total costs.

Why Are Expense Ratios Important?

​​Expense ratios matter because they reduce your investment returns every year, regardless of whether the fund gains or loses value. Unlike a one-time commission or load fee, the expense ratio is an ongoing cost that compounds over time.

For long-term investors, even a fraction of a percentage point can make a meaningful difference. Fees and expenses reduce the value of your fund's investment returns, requiring a higher-cost fund to outperform a lower-cost fund just to break even.

How Expense Ratios Can Affect Returns

The impact of an expense ratio grows over time because it reduces the balance that compounds each year. Here's an example assuming a $10,000 initial investment and a 7% gross annual return over 20 years:

In this example, the higher-cost active fund reduces your total 20-year return by roughly 16% despite both funds having the same gross annual return.

What's a Good Expense Ratio?

What counts as a good expense ratio depends largely on the type of fund you're investing in. Here's how to evaluate whether a fund's ratio is competitive:

• Compare within the same category: A ratio that's reasonable for an actively managed hybrid mutual fund may be high for a broad index ETF. Always benchmark against similar funds in the same asset class and management style.
• Look for passively managed options: Index mutual funds and ETFs typically charge significantly less than actively managed funds because they require less research and trading.
• Watch for fee waivers: Some funds temporarily waive fees to attract investors. Always check the gross expense ratio—not just the net—to understand what you may pay once the waiver expires.

Keep in mind that while a low expense ratio is an important factor when evaluating a fund, it isn't the only one. It's also important to consider the fund's performance history, investment strategy, risk profile and how well it aligns with your goals.

Expense Ratios for Different Fund Types

Expense ratios vary significantly based on how a fund is managed and what it invests in. The two primary factors are management style and fund structure.

Actively Managed Funds

Actively managed funds employ portfolio managers who research securities and make ongoing buy and sell decisions in an effort to outperform a benchmark. This requires more resources, which is reflected in higher expense ratios.

In 2024, the average actively managed mutual fund had an expense ratio of 0.89%, while the average actively managed ETF carried a ratio of 0.69%.

Passively Managed (Index) Funds

Passively managed funds are designed to track a specific market index, like the S&P 500. Because they require less research and trading, they tend to carry significantly lower expense ratios. Index funds averaged 0.60% for mutual funds and 0.48% for ETFs in 2024, though some index ETFs charge less than 0.10% per year.

Equity Funds

Equity funds invest strictly in stocks, but each one can be designed with a specific investment strategy in mind, affecting the potential costs.

While the average expense ratio for equity mutual funds is 0.40%, you may expect to pay more or less than that with different types of equity mutual funds. Here's a look at the averages, according to the Investment Company Institute:

Bond Funds

Bond funds typically carry slightly lower expense ratios than equity funds. In 2024, equity mutual funds averaged 0.40%, while bond mutual funds averaged 0.38% on an asset-weighted basis.

But as with equity funds, the cost you pay will also depend on the type of bonds you're investing in. Here are the averages for different types of bond mutual funds:

Other Fund Types

Here's a look at some of the other types of mutual funds you may be interested in and what to expect in terms of cost:

• Hybrid mutual funds: These funds invest in a mix of asset classes—typically stocks and bonds—within a single portfolio, offering both growth potential and stability depending on the fund's strategy. On average, hybrid mutual funds come with an expense ratio of 0.58%.
• Money market mutual funds: These funds invest in short-term, low-risk debt instruments like Treasury bills and commercial paper, making them a common cash alternative for funds you may need soon. The average expense ratio for a money market fund is 0.22%.
• Target-date mutual funds: Target-date mutual funds are funds of funds—meaning they invest in other funds rather than individual securities—that are built around a specific retirement year, automatically shifting from aggressive to conservative allocations as that date approaches. It's a common default option in 401(k) plans, and the average expense ratio is 0.29%.

How to Calculate an Expense Ratio

In plain terms, the expense ratio equals a fund's annual operating costs divided by its average net assets under management. You won't need to calculate a fund's expense ratio yourself because all funds are required by law to disclose it. Still, understanding the formula helps clarify what the ratio represents:

Expense ratio = Total annual fund operating expenses / Average net assets

Here's how the formula works in practice:

• Fund assets: $250 million
• Management fee: $1,000,000
• 12b-1 distribution fee: $300,000
• Other expenses: $200,000
• Total annual expenses: $1,500,000

$1,500,000 / $250,000,000 = 0.006 = 0.60%

This fund has an expense ratio of 0.60%, meaning you pay $6 per year for every $1,000 invested.

How to Find Funds With Low Expense Ratios

There are several practical ways to research and compare expense ratios before investing:

• Use a fund screener. Most online brokers and fund platforms offer screeners that let you filter by expense ratio. Tools like Fidelity's mutual fund and ETF screeners, Schwab's ETF screener and FINRA's Fund Analyzer are designed for this purpose.
• Compare within categories. Always compare expense ratios against similar funds in the same asset class and management style. A broad equity index ETF should be compared to other equity index ETFs, not to actively managed equity mutual funds.
• Look at the fund prospectus. The prospectus contains the official fee table, which breaks down every cost component, including any shareholder fees not captured in the expense ratio.
• Check shareholder reports. Funds are required to deliver shareholder reports twice a year. These reports include a breakdown of expenses and provide transparency into where costs are going.
• Review fund company websites. Many fund sponsors, such as Vanguard, Fidelity and Schwab, publish expense ratios prominently on individual fund pages alongside performance data.

Frequently Asked Questions

The Bottom Line

As you decide what to include in your investment portfolio, it's important to align your choices with your overall investment strategy and goals. While mutual funds and ETFs can be a great way to diversify your portfolio, it's important to understand the costs associated with these investment options, particularly the ongoing cost of an expense ratio.

Take your time to research and compare multiple funds to determine the right fit for you. If you're struggling to decide, consider consulting with a financial advisor who can provide you with personalized guidance.