What is expense ratio, exactly? This important metric should be understood by all investors. In a nutshell, it represents the proportion of fund assets that are used for administration, management and any other operating expenses. Any long-term investors should carefully consider the expense ratio of any funds or ETFs before committing, since increased operating expenses mean a lower return for the investor. Learn more about operating expense ratio and how it affects your investments by reading this simple guide.
What is expense ratio?
As previously mentioned, the expense ratio indicates the operating expenses of a fund or ETF compared to the total assets. When it comes to active investments, this covers the costs of a fund manager who will manage the investment strategy, including balancing the portfolio, selecting investments and various other tasks. As for passive investments, this will pay for things like licensing fees.
The operating expense ratio is given as a percentage. A fund with a 1% ratio per annum means that 1% of the overall assets will be used to cover expenses in the space of a year. For example, with an annual expense ratio of 0.9%, the operating expenses would be $9 per $1000 invested over a year. This is not explicitly billed, and is instead simply deducted from your returns.
How to calculate operating expense ratio
The formula to calculate operating expense ratio is relatively simple. To work out this metric, you should divide the total fund costs by the total fund assets. So if a fund has $50 million in total assets and costs $1 million to run in a given year, then its expense ratio would be 2% ($50,000,000 / $1,000,000 = 0.02)
You probably won’t have to calculate this yourself, however, as the ratio will usually be included in the fund’s documentation. Alternatively, you can also use an online expense ratio calculator for a quick and easy solution.
What is a good expense ratio?
Understanding the significance of expense ratios will help you to understand the value of an investment, particularly when combined with other metrics such as return on investment (ROI). However, since the operating expenses can vary greatly according to the type of fund or stock, there is no single answer on what is a good expense ratio. One simple rule to remember is that lower is better. The lower the expense ratio, the lower the fees that you will pay for management of the fund and the more returns you will see.
As a rule of thumb, it’s good to aim for an operating expense ratio of less than 1%. Nowadays, some passive funds are even offering expense ratios of 0%. Having said this, the situation is usually more complicated than this, and you should consider the ratio along with other factors. Funds that have low expense ratios are not automatically good investments, and those with high expense ratios can also make good investments. If the ratio is high, then you should expect some kind of special service that justifies the higher cost.
What other factors are important for investment?
Expense ratios aren’t the be-all and end-all when it comes to making a good investment. You should analyze the value of an investment using these ratios in conjunction with other factors. For example, it’s a good idea to consider how the fund fits in with your investment strategy and the rest of your portfolio. The cheaper option is not always the one that complements your other investments.
In addition to this, elements such as taxes, the amount of trading that you do and the overall time frame of your investment strategy should be taken into consideration.
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