Mutual Funds: What is Expense Ratio?

Mutual funds are investment vehicles that offer many advantages to investors such as diversification, liquidity, and professional management. However, these services are not offered for free. Instead, they are associated with specific costs and fees.

The expense ratio represents the fund's annual expenses expressed as a percentage of the fund's assets. The good thing about the expense ratio is that it includes all the various costs and expenses of a mutual fund into one number, thus making it easy for investors to avoid many calculations. The typical expense ratio for an actively managed fund is approximately 1.5 percent and what it means is that the total value of the fund is reduced by 1.5 percent every year regardless how the market performs. Even if the stock market doesn't outperform the fund, the fund will pay itself 1.5 percent yearly. Considering the market conditions as they are today, that the market is unlikely to outperform the fund, a wise investor should consider that owing an actively managed fund is probably an expensive investment. On the other hand, passively managed funds have lower expense ratio. But also, an aggressive growth equity fund has a higher ratio than an equity income fund. Therefore, a knowledgeable investor should consider all factors.

The expense ratio consists of the following components:

(1) Management fees are fees charged for the administration of the fund. On average, management fees range between 0.5 percent and 2 percent annually of the fund's assets and are associated to investment research, portfolio management and administrative duties.

(2) 12b-1 fees, also referred to as distribution and service fees, range between 0.25 percent and 1.0 percent of the fund's assets and are associated to marketing and advertising expenses, distribution costs, and commissions paid to brokers, and other operating expenses.

(3) Administrative costs involve the costs of customer service, mailing, record keeping etc. Typically, administrative costs can be as low as 0.2 percent of the fund's assets, but for funds that use colorful graphics and imprinted paper, they may rise to 0.5 percent of the fund's assets or even higher.

Unlike mutual funds, expense ratio for index funds ranges between 0.18 percent and 0.25 percent. However, this doesn't mean that this is always the case. There are mutual fund companies that take advantage of the fact that many investors prefer index funds for their low expense ratio and therefore, they increase their expense ratio to 1 percent or even higher. As a matter, if one compares the tables in the newspapers, it is amazing how big brokerage firms charge 1.5 percent to 2.0 percent, while Vanguard charges less than 0.5 percent.

Overall, the behavior of mutual funds is closely related to investor behavior and the behavior of brokers. There are overactive traders who buy and sell without sense and there are investors who are market-timers. All these factors, admittedly, affect the performance of mutual funds and inhibit the portfolio evolution on a long-term horizon.

Sources:

http://www.investopedia.com/terms/e/expenseratio.asp

http://www.fool.com/personal-finance/general/2006/11/15/whats-an-expense-ratio.aspx

http://mutualfunds.about.com/od/mutualfundglossary/g/expense_ratio.htm