What’s an “expense ratio”?
There are a number of activities that go into operating a fund, including investment management, administration, and shareholder support services. And there are costs associated with each of these functions, which are represented as a fund’s expense ratio.
The expense ratio is a percentage of a fund’s net asset value (NAV) that’s deducted annually to cover these costs. It’s withdrawn directly from the fund’s NAV before returns are calculated and distributed to investors.
The expense ratio is reflected in each fund’s NAV. You won’t see the expense ratio as a separate fee.
Typically, each expense ratio reported in a Vanguard fund prospectus and in the Funds, Stocks & ETFs section of our website is backward-looking: It represents the costs incurred by the fund during its previous fiscal year divided by average fund assets during that year. The expense ratio that results from this calculation appears in the updated prospectus that Vanguard files annually with the U.S. Securities and Exchange Commission.
Why do expense ratios change?
As with any ratio, a mutual fund’s expense ratio can change based on changes to the numerator (costs), the denominator (average fund assets), or both.
A fund’s expense ratio may be adjusted because of changes in the value of fund assets. For actively managed funds, the terms of the contract between Vanguard and third-party investment advisors can also trigger an expense ratio change.
When assets grow (whether from market appreciation or cash flow), a fund achieves economies of scale: Fixed costs spread over the larger asset base represent a smaller share of assets. Conversely, if fund assets decline—as they did during the bear market from 2007 to 2009—fixed costs represent a larger slice of fund assets, driving up the expense ratio.
For actively managed funds, most of Vanguard’s contracts with external advisors include a base fee plus or minus a performance adjustment. If the advisor outperforms the designated benchmark index, the firm’s fee increases. This is good news for shareholders, as they directly benefit from the advisor’s superior results. If the advisor underperforms, the firm’s fee declines.
The incentive-fee structure helps to ensure that the interests of the advisor and the fund’s shareholders remain aligned, regardless of market conditions. Click View prospectus and reports on each fund’s Overview page for more information on performance-based fees.
Why costs matter
What do all these numbers mean to you? A hypothetical fund with a 1.0% expense ratio charges you $100 each year for every $10,000 you’ve invested in it. A fund with a 0.2% expense ratio charges you $20 each year. Over time, differences like that can really add up.
Bringing down the cost of investing
Several studies have shown that funds with lower expense ratios, as a group, deliver better performance than higher-cost funds—because investors keep more of their returns.* We have a long history of adding value for shareholders by reducing the expense ratios of our funds. The average expense ratio for Vanguard funds offered for sale in the United States decreased from 0.89% in 1975 to 0.19% in 2015. (Source: Lipper, a Thomson Reuters Company, and Vanguard.)
But as we explained above, an increase in a fund’s expense ratio is not always bad news for investors, and a decrease isn’t always good news. It depends on the reason for the change. *For example, see Shopping for alpha: You get what you don’t pay for.