What is the expense ratio?
This article is for educational purposes and does not constitute financial, legal, or tax advice. For specific advice applicable to your business, please contact a professional.
The expense ratio is the ratio of an investment fund’s operating expenses to its assets. It is also sometimes known as the management expense ratio (MER), the operating expense ratio (OER) or the before reimbursements expense ratio (BRER). The expense ratio is one way to determine if a fund is offering value for money.
Example of expense ratios
The basic approach to calculating the expense ratio is:
TER = Total Operating Expenses (OPEX) / Value of Total Fund Assets
Brokerage and trading costs are excluded from operating expenses. Asset value is the average value of all assets held by the fund.
This calculation gives the gross expense ratio. Many funds will also provide the net expense ratio (also known as the after reimbursement expense ratio). The net expense ratio excludes any expenses that are recouped, recovered, reimbursed or simply waived.
Both ratios have their uses. The standard total expense ratio (TER) is, however, generally the one to which investors should pay the most attention.
Why the total expense ratio (TER) matters
There are basically two ways investors can manage their portfolios. They can do so themselves or they can hire someone else to help them.
Hiring someone else to help you manage your investments increases the cost of investing. Investors, therefore, need a way to judge whether or not an investment manager (or management team) delivers enough overall value to justify these costs.
The total expense ratio (TER) is a convenient way of forming an initial judgement on whether an investment fund is worth its management fees. As a rule of thumb, the TER should be between 1% and 1.25%. Funds with safer investment profiles should be on the lower side and vice versa.
Why total expense ratio (TER) is more reliable than net expense ratio (NER)
The total expense ratio (TER) is more reliable than the net expense ratio (NER) because it shows the fund’s standard operating costs before any discounts are applied. It, therefore, shows what investors should expect to pay if all charges are applied at standard rates.
The NER, by contrast, takes into account any discounts that have been applied during the relevant accounting period. This means it is only a valid reflection of what investors paid during that specific accounting period.
The reason this matters is because most investment funds have three main areas of expenditure. These are: payments to managers, distribution fees and general expenses. Some of these costs are fixed (such as taxes). Others are discretionary – at least to some extent.
With actively managed funds (as opposed to index trackers), the single-biggest cost by far is management fees. These are driven by the market, but unlike wages/salaries for regular employees, however, they tend to be highly discretionary.
If a fund is operating in a competitive market, its managers may choose to waive/reimburse some of their fees. This creates a more favorable NER, but only for that period. Once the market stabilises, the management fees will almost certainly be increased. This means that investors should look at the TER to see what the fees are likely to be over the long term.
Why the total expense ratio (TER) can be misleading
A fund’s TER is generally best viewed as a useful guideline rather than a hard-and-fast indicator of a fund’s overall value.
For example, passively-managed funds (often known as index trackers) will almost inevitably have a low operating expense ratio. This is because the funds are largely managed by computer algorithms with very little human input.
At the other end of the scale, there are investment funds with very high operating expense ratios. Sometimes, these can be entirely justified.
As a rule of thumb, the more risky and/or niche an investment category is, the higher its management fees will be and hence the higher its operating expenses will be.
Paying these costs, however, can allow investors to access market sectors they could not safely have navigated on their own. It could therefore allow them to diversify their income in ways they might otherwise have missed.
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