ETFs, like mutual funds, pool investor money so that a professional portfolio manager can invest those funds in a particular market index or with a specific strategy. These portfolio managers must be paid for their services, and other costs must be covered including overhead, marketing, and trading fees. All of these fees are bundled together into the fund's expense ratio.

Expense Ratios

An expense ratio is what each investor pays into a fund on an annual basis in order to cover:

• Management fees
• Administrative fees
• Marketing costs
• Record-keeping fees
• Compliance costs
• Legal fees
• Auditing fees
• Shareholder service fees

When evaluating the cost of owning an ETF, you will often see two figures: a gross and a net expense ratio. These numbers are both important, but each will contain different expenses and convey different information about the fund's relative costliness.

Many investors find it difficult to understand the difference between gross expense ratio and net expense ratio. Here's how they differ.

Gross Expense Ratio

Gross expense ratio is the percentage of assets used to manage a fund before any waivers and reimbursements. Therefore, the gross expense ratio is what shareholders would have paid without those waivers and reimbursements. The gross expense ratio only impacts the fund, not the current shareholders.

For example, if an exchange-traded fund has a 0.40% gross expense ratio and a .10% net expense ratio, that would indicate that 0.30% of the fund’s assets are being used to waive fees, reimburse expenses, and offer rebates. (Whether such an arrangement would be sustainable for the fund, and therefore worthy of your investment, would be for you to decide.) That said, if you see a gross expense ratio above 1%, you should be wary; the average fund expense ratio is 0.47%.

Net Expense Ratio

The net expense ratio (sometimes known as the total expense ratio) comes out of the share price after waivers and reimbursements. In some cases, a fund may have agreements in place for waiving, reimbursing or recouping some of the fund’s fees. This is often the case for new funds.

An investment company and its fund managers may agree to waive certain fees following the launch of a new fund to keep the expense ratio lower for investors. The total expense ratio represents the fees charged to the fund after any waivers, reimbursements, and recoupments have been made. These fee reductions are typically for a specified time frame after which the fund may incur full costs.

Instead of what shareholders would have paid, the net expense ratio is an actual payment as a percentage of assets under management.

Understanding Waivers & Reimbursements

Newer and smaller funds will usually have higher gross expense ratios because they cost more to run on a relative basis. However, smaller funds will use waivers and reimbursements in order to attract new investors. Think of it like a retailer running a promotion to get more customers into the store, or a new supermarket that lowers prices to steal share from an existing brand. After several weeks or months, the store will raise prices again to improve its margins. Like the retailer or supermarket, a fund may end the promotional period for an ETF after a time. This is most typically seen with actively managed ETFs which have higher fees.

If the gross expense ratio is higher than the net expense ratio, then as an investor, you’re betting that assets under management will grow enough to offset those expenses. If that’s not how the situation plays out due to poor performance, then waivers will be eliminated. The wider the spread between the gross expense ratio and net expense ratio, the more likely waivers will be eliminated. Also look for the waiver end date if available. In simpler terms, if the gross is higher than the net, it increases the odds that the fund’s expense ratio will move higher in the future.

The good news is that if the fund can grow its assets under management, then the fund becomes less expensive to manage, which then lowers the expense ratio. As an investor, this would be beneficial because higher expense ratios eat into your profits and exacerbate your losses.

However, this situation tends to only occur with active ETFs, where a fund manager is actively trading to try to beat the market. Most ETFs passively track an index, sector, or some category of investment assets. Passive ETFs, which are the vast majority of ETFs, have very low fees to begin with and typically will not have promotions. Fee waivers for passive ETFs can happen, but tend to be smaller and less common given most funds' already low cost.

Other Important ETF Factors

When you read about expense ratios, it's typically referring to the net expense ratio. You can find a fund's net expense ratio by entering the fund's ticker symbol on Yahoo Finance or other similar apps. The ETF page will display the net expense ratio and many other pieces of information about the ETF.

If that expense ratio is above 0.24%, then it’s above the average for ETFs, specifically (not including mutual funds). This doesn’t mean you should eliminate that ETF from investment consideration, but it does mean you will have to do some research. There may be another ETF that tracks the same thing but offers a lower expense ratio.

Turnover

Note the Annual Holdings Turnover in the Fund Operations section. If that percentage is high, then it indicates active management and will usually mean a high expense ratio. Passive ETFs usually have a low turnover and a low expense ratio due to their lower overhead costs.

Volume

Expense ratios are important, but they’re not the only metric to look for when choosing an ETF. Also look at the average daily trading volume. If it’s above 1 million shares per day, then it’s liquid, which will allow you to buy and sell with ease. Anything above 100,000 shares traded per day can be OK, but check the bid-ask spread to make sure it’s tight. Otherwise, you can be hit with hidden costs. In order to avoid this, use limit orders opposed to market orders.

Volatility

If you’re going to trade volatile leveraged and inverse ETFs, then you should strongly consider having a specific game plan for buying shares and an exit strategy. Otherwise, the daily rebalancing, high expense ratios and commission fees have the potential to lead to a significant hit. It should also be noted that these are extremely high-risk instruments.

The Bottom Line

As an investor, you don’t pay into the gross expense ratio on an ETF. But if you see a wide spread between the gross and the net, it could indicate higher expenses down the road because it’s more likely that waivers and reimbursements will be eliminated. Also be aware of other risks associated with ETFs, especially for those that are actively managed.