Expense ratios are fees that exchange-traded funds (ETFs), mutual funds, closed-end funds, and money market funds charge their shareholders. This fee is called a “ratio” because it is quoted as a percentage of assets per year, e.g. 0.85%. The expense ratio includes the administrative, operating, and legal costs involved in managing the fund, and sometimes even marketing costs (called 12b-1 fees) to distribute the fund.
The expense ratio is important to consider when you invest in a fund. Even though you will never see a deduction of this fee from your account, you’re still paying it. It’s built into the price of the fund, so it accrues daily, and is proportional to your investment in the fund. Therefore, this expense directly impacts your return in the fund—and ultimately your wealth.
For that reason, it’s important to compare the expense ratios of funds from different providers within an asset class. Additionally, some asset classes are inherently more expensive than others. For example, U.S. stock funds generally have a lower expense ratio than international stock funds, whose assets are more expensive to obtain. The strategy of the fund will affect its expense ratio as well. For example, passively managed index funds will have lower expense ratios than actively managed funds, despite their typically better net-of-fee performance.