Expense ratio is the percentage of assets of a fund which is expended each year on running expenses. It is calculated by dividing annual operating expenses of the fund by the average value of assets in the fund.
There are two flavours of the ratio: annual report (or audited) expense ratio (which relates to the past year) and prospectus expense ratio (which is the expected ratio next year). The expense ratio is different from total expense ratio.
Lower expense ratio is better because it tells that the fund is eating up a low proportion of its assets each year. Since net return of any fund equals the gross return minus expense ratio, funds with lower expense ratio are in a better position to generate higher net return.
Expense ratios depend upon the size of the fund (lower funds have higher expense ratios), the management style (active funds have expense ratios), etc.
|Expense Ratio =||Fund Operating Expenses|
|Average Assets in the Fund|
Expenses include management fees paid to the investment manager, 12b-1 fees paid for promotion of the fund, audit fees paid to auditors, fees paid to record-keepers and legal advisers, etc. However, they exclude transaction costs paid to brokers.
Lower expense ratio is better because it means that the running costs of the fund are lower. Lower costs in turn means higher net return for the investors.
The following table outlines calculation of expense ratio of a (fictional) investment fund named Global Equities Active Fund.
|Amount in million $|
|Assets at the start of year||600|
|Assets at the end of year||700|
|Fund manager's fee||6|
|Distribution and promotion fees (12b-1)||0.1|
Average assets for all the fund are worth $650 million [=(600 + 700) ÷ 2].
|Expense Ratio =||6 + 0.1 + 0.9|
Expense Ratio = 1.077%