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What is an expense ratio?
The expense ratio is a measure of what it costs an investment company to operate an asset fund. Investors research them to determine the rate of return on a potential investment.
Mutual funds, exchange-traded funds (ETFs), and other types of investments charge fees to shareholders determined by an expense ratio. The ratio is expressed as a percentage and is calculated by dividing the fund’s operating costs by the average dollar value of assets under management. Such operating costs could include payments to management, advisers, and bookkeepers; taxes and legal expenses; and what are called 12b-1 fees, which pay for marketing and distribution. The result tells you what percentage of the fund’s assets pay for its expenses.
High expense ratios indicate a reduction in the value of the investment, while a low ratio means the asset value helps offset the fund’s expenses.
Small funds often have a high ratio, because even though the assets in the fund are limited, it must still meet management and administration fees. Larger funds might have a low expense ratio, as the costs are spread across a wider asset base. In some cases, a fund may waive a portion of its operating costs.
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Expense ratio example
Mary is looking at different types of investments to put her money into. She finds a bond fund and puts $10,000 into it, and, after researching it, she discovers that its expense ratio is 1.4%. Over the next year, her returns averaged 5%. However, she doesn’t collect the full amount; rather, she earns 5% minus 1.4%, or 3.6%. Her actual returns are $360 instead of $500, meaning that the expense ratio consumed 28% of her returns.