Mutual funds are a great way to invest in the stock and bond markets without incurring specific stock risk. These funds are managed by a professional team of investment personnel, who can provide individuals with a way to participate in the market in a diversified manner. Selecting a mutual fund requires carefully considering the individual's goals matched with the fund’s objective.
Information pertaining to a mutual fund’s objectives is contained in its prospectus, which is a document provided by the fund company. The prospectus contains all the important facts about the fund including components of fees associated with the fund. Individuals who invest in mutual funds pay the fees associated with managing the fund, and also fees associated with selling and operating the fund and the firm. Some mutual fund expenses are not borne directly by the investor, but indirectly by reducing the return received by the investor. Mutual fund expenses are a critical component in deciding whether to invest in a fund.
Fees associated with a mutual fund comprise the aforementioned sales charges as well as other transaction fees, account fees and fund expenses. Fund expenses include, among others, management fees and operating fees. Investors frequently confuse the management fee with the management expense ratio (MER). The management fee is often used as the key determinant when making an investment decision, but the MER is an even broader measure of how expensive the fund is to the investor.
Management Expense Ratio vs. Management Fee
A mutual fund incurs many operating fees associated with running a fund other than the costs to buy and sell securities and pay the investment team making the buy/sell decisions. These other operating fees include marketing costs, legal, auditing and filing costs, and other administrative costs. While these fees are not directly involved with making the investment decisions, they are required to ensure the mutual fund is run correctly and within the Securities and Exchange Commission's requirements.
The management fee encompasses all direct expenses incurred in managing the investments such as hiring the portfolio manager and investment team. Note that the cost of buying or selling any security for the fund is not included in the management fee. Rather, these are transaction costs and are expressed as the trading expense ratio in the prospectus. Together, the operating fees and management fees make up the MER.
A fund’s prospectus provides the expense data for the fund each year. The management fee is significant for the fund, because the cost of hiring and retaining the investment team is the most expensive part of managing a mutual fund. Therefore, the management fee is often cited as the fee to review. However, looking at the MER is a better determinant of how the fund company manages its expenses related to managing the fund.
Reviewing these fees in the prospectus may not always be straightforward depending on what wording the mutual fund company uses. Most companies label the management fee as is, but the MER can be labeled several ways. Below are some examples from actual fund company prospectuses:
Fund Company #1:
Management Fee: 0.39%
Total Annual Operating Expenses: 1.17%
The individual investor needs to calculate the MER, which in this case is 1.56%
Fund Company #2:
Management Fee: 1.80%
Fund Expenses Indirectly Borne by Investors: 2.285% (expressed as $22.85 for every $1,000 investment)
The language used to describe the MER may not be uniform from fund company to fund company, so careful review of the prospectus is required.
Impact on Returns
Reviewing expenses before investing in a mutual fund is critical to making an informed decision. When the prospectus says “Fund expenses indirectly borne by investors”, the key word is “indirectly”. While investors do not receive an annual bill for the fund expenses, they are charged for the expenses through a reduced return that the fund will pay. However, to make reviewing the prospectus easier, mutual fund companies are required to show the performance of the fund net of expenses. By showing the return net of expenses, it provides clarity to the investor when deciding whether to invest in the fund or in establishing what the fund is yielding or returning to the investor. As a result, comparing across fund companies is simplified, and the returns are uniformly presented and real (actual).
The Bottom Line
Having a clear understanding of the fees charged by a mutual fund is a significant component to making an informed investment decision. Often the management fee is used interchangeably with the MER by business publications and financial professionals, but the two are not the same. MER includes many fees, one of which is the management fee. As a result, in general MER is often higher than the management fee.
However, there are instances when the MER may be lower than the management fee. These circumstances are rare, but they occur when the mutual fund company absorbs some costs, such as when a fund is new and has few assets. Because some of the operating costs are fixed, when a fund is starting out and has few assets, these fixed costs are high. Therefore, a fund company will absorb some costs and show the MER at a level it expects it to be when more assets are gathered into the fund.
Another circumstance when a fund company will absorb expenses is during anomalies in the market, such as the extremely low interest rate environment in 2010. During this time, money market funds saw expenses that exceeded returns, so the fund companies absorbed some expenses. Because there may be unusual occurrences from year to year, reviewing the management expense ratio and management fees over several years should provide a broader picture of the fund’s typical expenses that investors will indirectly bear.
Mutual Funds & ETFsThere is money to be made in mutual funds, but investors fall into several pitfalls that keep them from maximizing their profits. Read these tips to take the uncertainty out of investing in mutual ...
Mutual Funds & ETFsUnhappy with your mutual fund's returns and thinking of investing elsewhere? Read this article first.
Mutual Funds & ETFsLearn how to evaluate mutual funds and find the right one for you.
Mutual Funds & ETFsThese statistical measurements highlight how to mitigate risk and increase rewards.
Active Trading FundamentalsFind out whether a fund's performance is a result of the manager's abilities, or just a fluke.
Mutual Funds & ETFsThe lower the sales charge you pay, the greater your returns. Find out how to cash in.
Mutual Funds & ETFsDetermine how fund managers are doing by sizing them up against their peers.
Mutual Funds & ETFsFund managers often take on more risk than they should, putting business ahead of fund holders' interests.
InvestingBeing vigilant about the amount you pay and what you get for is important, but adding ETFs into the investment mix fits well with a value-seeking nature.
Mutual Funds & ETFsFind out what kinds of mutual funds are unsuitable for millennial investors, especially when included in millennial retirement accounts.
The portfolio turnover percentage can be used to determine the extent to which a mutual fund turns over its stocks and assets ... Read Full Answer >>
Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
Financial advisors are reimbursed by mutual funds in exchange for the investment and financial advice they provide. A financial ... Read Full Answer >>