Expense ratio: What is it & when is it used?

Defintion

An expense ratio, in financial terms, refers to the percentage of a mutual fund or an exchange-traded fund’s (ETF) assets that are used to cover the fund’s operating expenses.

What is an expense ratio?

These operating expenses include various costs associated with managing and administering the fund, such as management fees, administrative fees, custodian fees, marketing expenses, and other operational costs.

The expense ratio is expressed as a percentage and is calculated by dividing the total expenses of the fund by its average assets under management (AUM) over a specific period, usually a year. This ratio is important for investors because it reflects the proportion of their investment that goes towards covering the fund’s ongoing costs.

A lower expense ratio is generally preferred by investors, as it means a larger portion of their investment is working to generate returns rather than being used to cover expenses. Expense ratios can vary significantly between different funds and investment products, so it’s important for investors to consider this factor when choosing where to invest their money.

Example of expense ratio

Let’s consider the “XYZ Equity Fund,” a mutual fund that manages a diversified portfolio of stocks. The total assets under management for the fund are €100 million, and the annual operating expenses incurred by the fund, including management fees and administrative costs, amount to €1 million.

$Expense ratio = (Total operating expenses / Total assets under management \times 100$

Using the numbers provided:

In this example, the expense ratio for the XYZ Equity Fund is 1%. This means that 1% of the fund’s total assets are used to cover its operating expenses on an annual basis.