Definition
Expense Ratio (Passive Funds)
The expense ratio is the annual cost of running a fund, expressed as a percentage of assets, and is a primary driver of an index fund's or ETF's tracking difference versus its benchmark.
Indian passive funds compete heavily on expense ratio, since for a product designed to mirror an index, lower cost almost mechanically means closer tracking. Broad-market index ETFs and funds carry some of the lowest expense ratios available, often a small fraction of active-fund charges.
The expense ratio is the largest predictable component of tracking difference, the cumulative shortfall against the index. When comparing similar index funds, the lower-cost option will, all else equal, lag the benchmark less, which is why cost discipline is central to passive investing.
Related terms
- Tracking ErrorTracking error is the standard deviation of the difference between an index fund or ETF's returns and its benchmark index's returns, measuring how consistently the fund follows the index.
- Tracking DifferenceTracking difference is the actual cumulative return gap between an index fund or ETF and its benchmark over a period, typically negative because of fees and costs.
- Cash DragCash drag is the small performance shortfall an index fund or ETF suffers from holding uninvested cash, which earns less than the index when markets rise and contributes to tracking error.
- Index FundAn index fund is a passively managed mutual fund that aims to replicate the performance of a market index by holding the same securities in the same proportions, at low cost.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.