Investment funds such as mutual funds and exchange-traded funds (ETFs) pool investor money to purchase financial securities. Performing all the functions required to run a fund involves costs.
These expenses include management fees, distribution fees, and other operating expenses. When viewed as a percentage of the funds’ assets, these operating fees are called the expense ratio.
The gross expense ratio includes all of a fund’s operating expenses, while the net expense ratio subtracts any fees that are waived, recovered, reimbursed, or recouped.
What’s the Difference Between Gross Expense Ratios and Net Expense Ratios?
|Gross Expense Ratio||Net Expense Ratio|
|Includes all fund operating expenses||Reduced for waivers and reimbursements|
|Must be reported, as investors may have to pay some of the expenses||May be reported, as expense reductions may not last|
|Does not include brokerage and trading fees||Does not include brokerage and trading fees|
Fund Operating Expenses
The expenses to operate a mutual fund or ETF are charged to the shareholders indirectly by deducting them from the fund’s assets. These fees can include:
- Management fees: These fees are paid to the fund’s investment advisor for analyzing, buying, and selling the securities for the fund’s portfolio on behalf of the investors.
- Distribution fees: These fees, also known as 12b-1 fees, are incurred to market and sell shares of the fund. They include things such as advertising and broker compensation. They also include fees paid to people hired to respond to investor questions and provide the relevant information they need.
- Other expenses: This category generally includes administrative fees that don’t fall into one of the other categories. Examples include legal fees and accounting expenses.
When these fees are totaled and expressed as a percentage of the average net assets of the fund, it is called an expense ratio. This is the easiest way to illustrate the fund’s total operating expenses. For example, if a fund with average net assets of $500 million costs $5 million to operate on an annual basis, the expense ratio is 1%. This is the gross expense ratio because it includes all the fund’s operating expenses.
However, some of the fees may be waived or reimbursed, thereby reducing the total expense to shareholders. The fund may wish to report the expense ratio to investors and prospective investors without these expenses because it illustrates a lower cost to own shares in the fund.
If, in the $500 million fund example above, a total of $1 million in operating expenses was waived or reimbursed, then the net operating cost would be $4 million. As a percentage of the fund's $500 million in assets, that is 0.8%. This is the net expense ratio because it reflects the fee reductions.
Reporting Gross Expense Ratio and Net Expense Ratio
Funds are required to report their gross expense ratio in their sales material. The reason the gross expense ratio’s disclosure is required is because it reflects the cost of owning shares in the fund, provided the fee waivers and reimbursements are not in place. If the net expense ratio were reported and the same waivers or reimbursements were not available in the future, that might cause an investor to pay more for the fund then they realized.
Funds are allowed to report their net expense ratios, but they still must present their gross expense ratio, and do so in a balanced way.
If the net expense ratio is presented, the fund must disclose information about the nature of the fee waivers and reimbursements that are in effect—such as whether they are contractual or voluntary, and how long any fee waiver or expense reimbursement obligation remains in effect.
Inclusion of Brokerage or Trading Fees
The annual operating expenses are not the only expenses an investor may have to pay to purchase or own shares in the fund. There may also be brokerage fees or trading fees the investor must pay. These fees are also called “shareholder fees” and are not reflected in either the gross or net expense ratio. These include, if applicable:
- Sales loads: Typically a percentage of the sales price you pay for purchasing the fund to compensate the broker who sold you the fund.
- Redemption fee: Charged when you redeem your shares with the fund.
- Exchange fee: A fee for switching from one fund to another in the same family.
- Account fee: You may incur a fee if your account falls below a certain minimum value.
- Purchase fee: Similar to a sales load, but paid to the fund to offset some of the fund’s transaction costs.
Impact of Expense Ratios on Investors
Mutual fund and ETF expenses directly reduce the return investors earn on their portfolios. The higher the fund's expenses, the more substantial the investment performance has to be to provide returns in excess of that fee. A fund with a lower expense ratio does not have as high a performance hurdle to clear.
Over time, high investment fees can drag on your investment performance, so it is important to know the fees associated with the investments you choose.
Gross and net expense ratios help you understand what you are paying in total and in part so you can compare fund expenses appropriately. As long as the stated fee waivers and expense reimbursements are in place, the net expense ratio is what you pay. However, it’s good to know what the fund's gross expense ratio is because it shows what you would pay if those fee reductions were eliminated.
The Bottom Line
Mutual funds and ETFs incur expenses to maintain their operations and manage portfolios on behalf of their investors. These operating expenses reduce the return on your investment. Understanding the difference between gross and net expense ratios can help you avoid higher-cost funds.