When investors choose mutual fund investments for their portfolios, it's important for them to think about some of the management costs associated with different fund options. All mutual funds pay a certain portion of their assets to management, which vary according to the class and the industry of the fund. The expense ratio is a way to evaluate this factor, and those using it benefit from learning the difference between a net expense ratio and a weighted average expense ratio.
The Use of Expense Ratios
Expense ratios are a measure of a mutual fund's costs associated with management. It's essentially a fee that investors pay in exchange for the investment services provided by the fund. Comparing expense ratios is an important part of choosing a mutual fund -- though it should be kept in perspective with other important factors such as the fund's year-over-year growth and relative risk. Expense ratios are reported in the fund's prospectus, and research services or investment advisers usually provide investors with the expense ratios of various funds.
Net Expense Ratio
The simplest form of the expense ratio is the net expense ratio. Net expense ratio is the fund's total operating expenses and management fees expressed as a percentage of its net assets, usually for the prior investment year. This figure excludes brokerage fees and other transaction costs. Investment professionals at Stanford University and the Investment Company Institute note that larger funds have lower expense ratios than smaller funds, owing largely to economies of scale.
Weighted Average Expense Ratio
Because net expense ratios are usually weighted the same for both small and large funds, they are calculated using a simple formula based only on overall expenses as a percentage of net assets. It's usually more useful for the individual investor to compare funds based on the expenses for the average dollar invested in a portfolio funds, which requires the use of a weighting formula that adjusts for the fact that larger funds control more assets. According to William Sharpe at Stanford University, weighted average expense ratios tend to be smaller than the often reported net expense ratio. Financial planners sometimes provide a weighted average expense ratio for comparison.
Prospectus Expense Ratio
Whether the expense ratio reported by financial professionals is weighted or not, it is usually reported alongside a different number called a prospectus expense ratio. For some investors, prospectus expense ratios are more relevant because they represent expectations of future expenses -- rather than the past ratio. If a firm's prospectus expense ratio exceeds its net expense ratio, it means new investors in the fund are likely to pay more in management fees than those who invested in the prior year.