ETF Expense Ratios: Everything You Need to Know

ETFs are known for their low expense ratios. But what is an expense ratio and why do low costs matter with investing? Learn how expense ratios work, how they are calculated and how to identify a good expense ratio. 

What Is an Expense Ratio? 

An expense ratio is a measure of a fund’s operating expenses. Expressed as a percentage, an expense ratio tells an investor how much they’ll pay over the course of a year to own a mutual fund or an ETF. These expenses pay for costs associated with fund operation, such as marketing, advertising, and management of the fund portfolio. 

For example, if an ETF expense ratio is 0.20%, the investor’s cost to hold the fund for a year is $20 for every $10,000 invested. 

How Is an ETF Expense Ratio Calculated? 

ETFs and other investment funds typically calculate the annual expense ratio by dividing the fund’s operational expenses by its average net assets. So if an ETF had average assets under management of $100 million during a given year, and the expenses to operate the fund that year were $200,000, the expense ratio for the fund would be 0.20%.  

How Does an Expense Ratio Work? 

An expense ratio measures a fund’s operating expenses expressed as a percentage. Thus, an expense ratio is a disclosure of fees, and it works more like a reduction of return than a bill charged to investors. Put simply, a fund company calculates its annual expenses and deducts those expenses from the portfolio’s trust, and not directly taken from the shareholders. 

A fund’s net return is the total return of the fund portfolio, less expenses. For example, if an ETF expense ratio is 0.10%, and the total return before expenses is 9.00%, the net return after expenses to the shareholders is 8.90%. Thus, the expenses are never billed to investors but deducted from the trust’s assets, thereby reducing the fund’s return to investors. 

From the shareholder’s perspective, an expense ratio works like a drag on returns. So, all other things being equal, the fund with the lowest expense ratio will produce superior returns compared to otherwise identical funds with higher expense ratios. 

What Is a Good Expense Ratio? 

A good expense ratio for an ETF or mutual fund is generally one that is below average. Trends in fund fees reveal that expense ratios have fallen substantially in the past 25 years. For example, Equity ETFs averaged 0.16% in 2021, down from 0.34% in 2009. Expense ratios of bond index ETFs averaged 0.12% in 2021, down from 0.26% in 2013. 

When evaluating ETFs, the lowest expense ratios are almost always preferred because many ETFs passively track the performance of an underlying benchmark. When two funds track the same index, the one with the lowest expenses will generally produce higher returns in the long run. However, higher expenses may be worth paying if the fund is actively managed and the returns have historically justified the higher fees.  

A good expense ratio also depends on other factors, such as the type of fund, the underlying assets or the management style of the fund. 

Factors impacting a fund’s expense ratio include: 

• Type of fund: ETFs are generally less expensive to operate compared to mutual funds, thus their expense ratios are typically lower. For example, equity ETFs average 0.16% expense ratios, whereas stock mutual funds average 0.47%. 
• Underlying assets: Equity funds generally have higher expenses than bond funds. 
• Management style: Passively managed funds typically have lower expenses compared to actively managed funds. 
• Assets under management: Economies of scale enable larger, more established funds to charge lower fees compared to smaller, less established funds. 
• Market cap: Operating costs and respective expense ratios are generally higher for actively managed funds investing in small cap stocks because there is less information, and therefore more research is required for small companies compared to large ones. 

How to Find the Best ETF Expense Ratios 

The best expense ratios are often the lowest, but with so many ETFs on the market today, researching and finding the cheapest funds can be challenging. A good way to find ETFs, and to sort by low expenses, is with an ETF screener. This research tool allows an investor to compare expense ratios by fund type, which enables an apples-to-apples comparison. 

For example, if an investor wants to research small cap ETFs, they could begin with the equity ETF universe, then select small cap focus. From there, the investor can sort the list from lowest expense ratio to highest.  

Investors should keep in mind that the lowest expense ratios don’t always indicate the best fund to buy. In addition to the expense ratio, investors are wise to look at historical returns and assets under management. 

Bottom Line 

An expense ratio is a measure of a fund company’s operational costs and represents how much an investor pays to own an ETF or mutual fund on an annual basis. The best expense ratios are often the lowest, but this is not always the case. For more information on finding the best ETFs for your needs, be sure to check out our articles, How to Build an ETF Portfolio and How to Choose the Best ETFs for Long-Term Investing.