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ETFs report annual expense ratios, such as 0.14% for Vanguard Total World ETF.
Let's say that I have invested $10,000 in the fund. I suppose that each year $14 is subtracted from my investment and paid to Vanguard, correct? Does Vanguard then use this amount to cover trading costs that are incurred by tracking the benchmark index? Or are those costs simply deducted in the fund's performance, so that the total costs for me are 0.14% + "loss compared to index"?
The money from the expense ratio is paid to the mutual fund management company. It pays for the employees, postage, website, lawyers, accountants, marketing, etc. It is not generally used to pay for transactions costs of the fund.
The transactions and exchange costs associated with subscriptions, redemptions, and rebalancing are additional expenses that are generally not paid out of the expense ratio. Investors must pay them, but they do not show up in the fund's stated expenses.
If two funds have the same expense ratio and track the same index but one has a higher turnover rate, then all else equal that fund will likely have higher trading costs and therefore underperform. Index funds are cheap not only because they have low expense ratios but because they normally have low turnover rates and therefore low transactions costs.
Note that when you look up a fund's performance, the returns you see are net of both the expense ratio and transactions costs.
