Expense ratio is the ratio of the expenses incurred by the management in order to run an Exchange Traded Fund (ETF) or a mutual fund divided the total assets held by the fund. In other words, it is the percentage of assets taken back by the management in order to run the fund.
Generally, the major expenses incurred by the fund are the management fees, which include mostly management fees and operating expenses, if any. Due to the fact that management fees take up bulk of the expenses, this ratio is also called the Management Expense Ratio. Another significant expense is the 12b-1 fees which is classified as marketing and promotion expenses under the FINRA rules. Other miscellaneous costs could be legal fees, auditing fees, accounting or recordkeeping and taxes, amongst others.
On average the expense ratio of an index fund (a passively managed fund) will be far lower than an actively managed mutual fund. Index funds seek to track the performance of a benchmark index (e.g. The Vangaurd 500 Index Investor tracks the performance of the S&P 500), meaning they generally refrain from trading except to keep the fund's portfolio in line with the benchmark index. In contrast, actively managed funds have much more freedom in ability to trade, and often trade frequently in search of market beating returns. As a result, operating expenses and thus the expense ratios are often larger for actively managed funds than for index funds.