- Expense ratio refers to the cost of running the mutual fund. It is calculated by dividing the fund's operating expenses by the average value of all of the fund's assets. These fees are charged regardless of any gains or losses of the fund, and are paid before any money is returned to the investors. Expense ratios vary greatly between funds, so you should pay attention to the fees charged by different funds, as this will directly affect your returns.
- By far the largest component of the expense ratio, often more than half, is the fund manager's fee. But it also covers any other operating costs, such as rent, accounting and legal fees, and administrative costs, such as record keeping and mailings. Some funds also include a 12b-1 fee, which covers marketing costs, such as advertising. Operating expenses are taken directly out of the fund's assets before determining the investors' return.
- While expenses are necessary and unavoidable, mutual funds are able to control the amount of the expense ratio by how well they control operating costs. More actively managed funds will naturally have a much higher manager's fee. If a fund charges a 12b-1 fee, one that advertises heavily on television and radio will naturally have a much higher expense ratio than one that markets through direct mail. The location of a fund's offices and the size of its staff also have an effect on its costs.
- Pay attention to expense ratios when comparing mutual funds. Some funds, especially smaller funds or those in more specialized sectors, can have expense ratios of 2 percent or more. Index funds, which are not actively managed, typically have much lower fees, with expense ratios as low as 0.2 percent. Look carefully at this number when comparing different mutual funds. The expense ratio also does not take into account any sales charges (called loads) or redemption fees. These fees, if applicable, are paid directly to the fund by investors, not taken out of assets.
- The expense ratio determines how great the return of the mutual fund will be. Imagine one fund has an expense ratio of 0.3 percent, and another of 2 percent. On a $10,000 investment, the annual charges for the first fund will be $30, while for the second, they will be $200. It is possible that the fund with the higher expense ratio could offset the difference by earning greater returns, but the difference in returns would have to at least be greater than the expense ratio to justify purchasing the fund.
