Expense ratio is the percentage of total assets used to pay for mutual fund expenses.
A mutual fund has a series of expenses related to the operation of the fund. That includes customer service people who fill your buy or sell order, people who issue shares, various reports, and related back office functions. The expense that most people notice is the cost of the investment managers.
A mutual fund has an annual budget for these expenses. Typically the fund closes its books at the end of the business day, calculates the value of all its investments, deducts its expense ratio (1/365th or the number of business days per year of the annual expense ratio) and then divides by the number of shares outstanding to arrive at the NAV each day. Hence most mutual funds collect their management fee from the fund daily.
How much expense ratio is appropriate varies with the fund type. Index funds do few transactions and hence require less research and management skill. They usually have the lowest expense ratios. Vanguard's 500 Index Fund (ticker VFINX) is the gold standard against which all other funds are compared. They have traditionally managed a 0.18% expense ratio, but numbers as low as 0.09 are possible for the Admiral shares sold to large accounts.
An actively managed fund claims that it needs more money to hire the best stock pickers and support them with adequate staff and research. A very large mutual fund gets by with a lower expense ratio, because it has many outstanding shares. A smaller competing fund can be forced to cut corners and may still have to charge a higher expense ratio.
Similarly highly specialized funds that appeal to a small select group may have higher expense ratios.
But then there are the sector funds that invest in a fixed collection of stocks with little management. Too often they have high expense ratios, and share holders are getting gouged. It's not worth it.
Some note that small cap funds also have the problem that they cannot take large positions in these small stocks. Hence, they have more research to do, more paperwork, and more expenses.
The bottom line is if you pay more than average expense ratio, make sure you get better than average performance, because index funds are still inexpensive. They are preferred unless some manager can consistently outperform their indexes.
Note that expense ratio is not the only expense paid by owners of mutual fund shares. Commissions and trading expenses are traditionally deducted directly from the trade. There are also 12b-1 fees used to pay for advertizing and marketing. And loads are often far larger than any of these expenses, but keep in mind that loads are paid only when shares are purchased. The other fees are smaller but paid daily, again and again.