One of the most appealing features of exchange-traded fund––aside from the ability to tap into a large variety of asset classes––has been their lower costs. Compared to regular mutual funds, ETFs are dirt cheap, as the average ETF has an expense ratio of about 0.43%. However, some broad stock market and bond indexes can be had for as little as 0.04%. This compares to an average 1.4% for traditional mutual funds. That cost savings has many investors switching over to the fund format [see The Cheapest ETF For Every Investment Objective].

But what exactly do those fees actually entail? Read on to find out.

What’s in My Expense Ratio?

The costs of owning a fund is called the expense ratio, which is expressed as a percentage of the fund’s assets. This ratio covers the investment advisory fee, administrative costs, other operating expenses and in the case of mutual funds, potential 12b-1 distribution fees. This is distinct from the costs of actually buying a fund, which involves brokerage commissions.

The investment advisory fee/management fee is the money necessary to pay the manager of the fund. In the case of broad index-hugging ETFs, this fee is usually pretty low as there is basically no “thought” required of the investment manager. Administrative costs represent the costs of record keeping, prospectus mailings, maintaining a customer service line and website. These also include accounting and other “backroom” costs of an ETF.

All of these fees are expressed in two ways: gross and net. Gross expenses of an ETF represent the cost of running a fund as compared to the profit earned by the sponsor, while the net expense ratio represents the gross expense ratio minus any acquired fees and waivers/reimbursements.

The primary difference between gross and net expense ratios has to do with their impacts on the investor. Gross expense ratios affect only the fund itself, while net expense ratios reflect the amount of money paid by each investor for the fund’s operating costs.

The real difference between the two ratios is basically how much of the operating costs a fund manager is willing to absorb and how much of those costs it charges investors. The expense waiver is the percentage of costs a fund sponsor is willing to eat in order to keep the fund’s net expenses low. Capped expenses are similar in that they represent the maximum a fund company is willing to charge for a set amount of time.

The Bid-Ask Spread

Aside from the operating costs of an ETF, investors need to be aware of the other fees that could impact their investment. One of the biggest impacts comes from wide bid-ask spreads. Essentially, the bid is the price that someone is willing to pay for a stock, ETF or other investment vehicle at a specific point in time, whereas the ask is the price at which someone is willing to sell. The difference between the two prices is called the bid-ask spread.