Expense Ratio

The expense ratio refers to the yearly fees levied on an investor by an exchange-traded fund (ETF) or mutual fund to manage their operating expenses using the percentage of total assets of funds. It aims to ascertain proper working and adherence to regulations while covering the costs related to owning a fund.

The ratio of expenses comprises miscellaneous, management, promotional, and administrative costs. Every investor has their expenses deducted automatically from their returns. This has been vital for investors in long-term investments, as even a minute discrepancy in expenses can hugely impact returns overall because of compounding effects.

The expense ratio can be stated as the total yearly operating expenditure divided by the mean of the total assets of a mutual fund. It provides the cost of running and compensating mutual funds or ETFs to the company. It is also expressed as the percentage of an investor's investment charged every year by a mutual fund company in exchange for managing the funds invested. Most index funds, such as ETFs or mutual funds, levy these charges on investments. 

Every day, investors' returns are deducted by the ratio of expense as long as they are invested in the fund or scheme. Some index funds incur low costs as their management is done by quantitative strategies instead of active human management. Fees charged directly decrease a portfolio's rate of return because they have a compounding effect. A higher ratio of expense means a higher deduction from returns, giving lower returns to investors.

Further, if a fund or ETF has a lower expense ratio, then it allows more funds from returns to be credited to investors. As a result, it helps investors compare two mutual funds based on a higher or lower expense ratio. Regulatory bodies have imposed restrictions on the expense ratio to protect investors and ensure proper capital flow in the markets.

Four main components comprise the ratio of expense as below:

• The fund manager charges management fees to manage the portfolio.
• Administrative expenses like accounting, legal, and custodial fees incurred.
• Distribution and marketing expenses are related to the marketing and distribution of products. 
• Miscellaneous expenses include taxes, audit fees, and other expenses. 

After all this, total operating expenses are found by taking a percentage of the mean of net assets fund to get the total expense ratio.

For common use, the formula for the ratio of expenses,

Total expense ratio = Total Fund Costs (expenses) / assets under management (AUM) *100

Where, 

• Total fund costs = cost of auditing, legal, management, interest, miscellaneous, custodian, trustee, and other costs.
• *100

Moreover, some websites offer expense ratio calculators for finding the ratios of the expense of mutual funds.

Let us use a few examples to understand the topic.

Example #1

Let us assume a mutual fund product A having AUM = $1,000,000

Its total annual cost of expenses by the fund management company, including its operational costs, administration, and promotion= $1,000

Hence, using the formula of the ratio of expense:

*100, where,

• Total expenses= $1,000 
• AUM = $1,000,000
• Therefore, expense ratio = *100 = 1%

This means that all investors in the mutual fund scheme have to pay a 1% annual expense ratio. Moreover, the expense ratio gets deducted on an everyday basis from funds NAV, impacting the investors' total returns till they are invested in the scheme.

Example #2

An online article published on 1 May 2024 discusses the seven best mutual funds based on their performance. The article decided it based on their 5-year returns, low costs plus minimums that also took account of US equity funds such as GVEQX and VQNPX. It is because GVEQX and VQNPX have been the best-performing mutual funds during the last 5 years. It was done to teach investors that portfolio management includes managing expectations and one should expect various returns from various categories of funds. 

These funds also have low costs that have expense ratios of equal to or less than 1%, requiring only a minimum investment of equal to or less than $3000 as per the table below: 

There have been significant impacts on returns, as shown below:

• It directly impacts the returns received by an investor as less money compounds over time.
• Compounding any small expense ratio difference can greatly impact returns. 
• For longer investment duration, the returns are majorly determined.
• It affects returns of active funds more than passively handled funds.
• Economies of scale decrease the expenses of large funds. 
• A slightly higher ratio of expenses offers good overall fund returns.
• Different components affect the ratio of expenses affected returns.