Summary

• An ETF's expense ratio is misleading, in some ways, as it only relates a fund's expenses to the size of its AUM.
• When trying to determine the true nature of the burden expenses place on a fund, it would seem desirable to relate them to the fund's income.
• It would serve the transparency of a fund better if expense reporting was standardized, with the data articulated in pertinent categories.
• I propose a new metric to be used to clarify the relationship between a fund's expenses and its distributions.

One aspect of ETF investing that is often listed as a "downside" when compared to investing in individual companies is the "expense ratio" (ER) - that usually small percentage (most frequently less than 1%) that represents the costs incurred by the fund's issuer in the course of managing the fund.

There is no "expense ratio" involved in owning stock in a company.¹

While a lot of ETF investors pay close attention to a fund's ER, I tend to put very little weight on it when deciding whether to invest in a fund. In fact, for many funds, I do not look at it at all. Why? Because on the whole I do not think that spending a lot of time worrying about ERs is needed, and is not really useful. I intend to explain why I feel this way in what follows.

What is the Expense Ratio?

In its most basic concept, the ER reflects the costs involved in managing a fund.² However, while the basic concept behind the ER may seem fairly straightforward, it is important to pinpoint as precisely as possible what it represents and how it is reached.

The following items are typically included as components of the ER:

• Manager/advisor fees
• Recordkeeping
• Custodial services
• Taxes
• Legal expenses
• Accounting/auditing fees
• 12b-1/marketing costs

What is not included in the ER:

• Costs associated with stock transactions (stock price, commissions, etc.).

Management fees can be found in a fund's annual report. The report should have a section titled "Statement of Operations," which will include income andexpenses. The problem is that issuers, while required to report the data to investors, are not required to identify exactly how much was spent on what particular item.

Many annual reports will simply identify the item "Management Fees," with a catchall "Other Fees" entry for anything that doesn't fit under the main category; others will provide a very detailed listings of fees.

Lack of standardization limits the extent to which the investor can make meaningful comparisons between funds, and there have been recent calls for making some enhancements to reports.³ It would certainly seem to be desirable to introduce some level of transparency and uniformity to these expenses that would articulate expenditures more than just a vague, overly general category.

Continue reading at Seeking Alpha.

Disclaimer

Funds mentioned herein are presented for illustrative purposes only; no recommendation or representation as to the fitness of those funds for investment purposes is intended.

¹ Or is there? Any company has its revenue, and there are costs involved in securing that revenue - the items that make up operating costs, and which are reflected in the operating margin.

² This is true whether one is talking about mutual funds or exchange-traded funds; I will be considering ETFs exclusively.

³ In "The Right Way to Show Fund Expenses," Morningstar's John Rekenthaler advocates breaking down management fees into five elements: portfolio management fees, administrative fees, operational fees, distribution fees and advisory fees. His schema is based on one being prepared by Morningstar's Paul Ellenbogen.