# How does a fund's expense ratio work?

There are several posts here but I cannot wrap my mind around it.

Suppose a fund has an expense ratio of 0.055%, as I understand it that means \$55 per \$1000.

Where do the expenses come from? Is every purchase of the fund reduced by 0.055%? So if a fund has a cost of \$100/share and \$1000 is contributed, its \$55 taken by the manager and then 9.45 shares are purchased?

• I've removed a load of comments that would belong best on an answer if still relevant. Feb 23, 2021 at 12:58

Suppose a fund has an expense ratio of 0.055%, as I understand it that means \$55 per \$1000.

If the expense ratio is stated as 0.055% that is actually around 5 hundredths of 1% of the total amount invested.

``````1000*0.055/100 = \$0.55 per thousand.
``````

Where do the expenses come from? Is every purchase of the fund reduced by 0.055%? So if a fund has a cost of \$100/share and \$1000 is contributed, its \$55 taken by the manager and then 9.45 shares are purchased?

The expenses are all the things they need to cover including required paperwork/filings, accounting, computers, staff. With a expense ratio that low it is most likely an index fund, so there is no need for a large staff to evaluate where to invest next.

They don't take the money from purchases because it is based on the current balances. Periodically they update this number to reflect actual expenses divided by the total amount currently invested. The fund takes the money to pay their expenses periodically from the cash the fund has. Each day there are transactions there is cash available, some of that cash is used to pay the expenses. Ultimately investors are having their returns reduced by the amount of the expenses.

If they took it from transactions it would either be a front-end sales load or a back-end sales load.

• I did not realize that is how the percentage is represented. I was aware of what kind of expenses are necessary, but even with your answer I'm unsure how (or if) my contribution amounts are affected by the expense ratio. Investopedia says that "investors are charged \$X for every \$Y a year", but if they don't come out of purchases, how am I charged? Feb 22, 2021 at 14:44
• @datta You are charged by getting fewer dividends. Imagine the compaines contained in the fund (where one share costs \$200) pay \$5 of dividends per fund share and per year. The dividends are paid to you once a year, and you then only get \$4.89, because the costs are \$0.11 per \$200 (0.055%) which are subtracted from the \$5. Feb 22, 2021 at 15:52
• @glglgl I see, thank you! What if the fund doesn't pay dividends? Feb 22, 2021 at 16:04
• @datta You see it as a function of your net return, if you mirrored their portfolio you'd see the difference between your return and the fund return is the expense ratio. Feb 22, 2021 at 16:08
• @datta It reduces the fund's NAV, so you'll receive less per share if/when you withdraw. Feb 23, 2021 at 15:12

An example explanation ... https://www.morningstar.com/invglossary/expense_ratio.aspx

I believe they:

• the fund has "one big bank account" with all the/any cash and obviously "one big holding" of the various stocks

• they calculate/decide on the current annual expenses. for example 5 staff members, 13 desk rentals, electricity bill, total is \$2.5m

• They divide \$2.5m by 365

• Each day they literally take that much out of the big bank account. (selling stocks if necessary, blah blah)

You account basically shows their current "grand total" divided by your share.

They already take the "costs for desks etc" out of the grand total, indeed on a daily basis.

Is every purchase of the fund reduced by 0.055%?

No. Simply, expenses are deducted every day (adding to the overall annual expense target).

So, say in theory a million people paid in \$1000 each to the fund so they have \$1b sitting there. So far they have not bought one stock. Each day an amount (call it \$5000) is deducted from the cash pile and goes to the "expenses" pile.

Say 100 days have gone by and still no stock purchase. So, the cash pile is down \$500,000.

They suddenly decide to buy every penny of Apple stock. So yes, instead of \$10b they would only be buying \$9.995b of Apple.

So this - "Is every purchase of the fund reduced by 0.055%?" - is not really correct, it's more along the lines of "they have slightly less available to buy stock than the overall sum of contributions"

So if a fund has a cost of \$100/share

it does not work like that, no

and \$1000 is contributed, its \$55 taken by the manager and then 9.45 shares are purchased?

No. The \$1000 just goes in the kitty. The overall kitty is decreased every single day by the expenses removal that day (which is indeed roughly fixed, perhaps "2 million a year", it's not a percentage as such). (Indeed also don't forget that as more people put in money, the percentage spent on expenses decreases.)

• Do a portion of my contributions go towards the big bank account or is it strictly for buying from the big holding? Feb 22, 2021 at 16:21
• don't forget by "big bank account" i just meant "all their money" like the sum of everyone's contributions, available to trade with. when you put money in, it simply indeed goes in the "big bank account". eventually the traders may decide to enter or exit their stock positions Feb 22, 2021 at 16:25
• if you're thinking of an index where trading is "automatic", I have no idea (and don't care) how they "instantly" balance the fund (probably with synthetics or such anyway). if they don't happen to have enough cash sitting around for today's expenses, they likely just sell a few shares. Feb 22, 2021 at 16:28
• So in essence, the lower the expense ratio, the further your money goes because the fund has more available to purchase stock with? Feb 23, 2021 at 11:58
• Exactly that. Anything spent on cost is gone and will not create any return. And as funds copying the same index will basically have the same performance, cost is the major factor for deciding which index fund to invest in Feb 23, 2021 at 13:00