A mutual fund's expense ratio is the result of a calculation, as opposed to a type of expense. The ratio's numerator is the sum of a variety of administrative and operating expenses, while its denominator is an average of the fund's assets. It is expressed as a percentage - lower is better - and is a key indicator of a fund's investment quality.

In general operating terms, stock funds are more expensive than bond funds, international funds are more expensive than domestic funds and small- and mid-cap funds are more expensive than large-cap funds.

The largest component of a fund's operating expenses is the fee paid to its investment advisors or managers. A fund must also pay for record keeping, custodial services, taxes, legal costs, and accounting and auditing fees.

In addition to these conventional operating expenses, some funds also have a marketing, or distribution, fee commonly referred to as a 12b-1 fee. If this fee is charged, it is included in a fund's operating expenses, unlike a fund's sales charge, which is not considered an operating expense. In the mutual fund industry's early days, a provision in the regulations permitted funds to incur promotional expenses to help develop mutual fund activity. The maximum 12b-1 fee allowable is an annual 1% of a fund's assets. To be considered a no-load fund, the 12b-1 annual charge must be no more than 0.25%.

Many mutual fund observers find it hard to justify this type of fee. With the increasing popularity of mutual funds, how much more "promotion" is really necessary? Today, the 12b-1 fee is used almost exclusively to reward intermediaries for selling a fund's shares. There is a movement underway to eliminate the fee, but the fund industry as a whole is resisting the change.

Lastly, it seems that some mutual fund investors are not all that clear on how operating expenses are paid. The simple answer is that whatever is included in a fund's operating expense is charged against the assets under management. In other words, the fund's investors pay the tab. This is how costs reduce investment returns.

Related Reading:

Commission & Redemption Fees

Related Articles
  1. Trading

    Fund Costs and Expenses

    How much a fund charges for its services is the most important indicator of how well it will perform.
  2. Investing

    12b-1: Understanding Mutual Fund Fees

    Many mutual funds charge investors a 12b-1 fee to pay for marketing and promotion expenses.
  3. Investing

    Mutual Fund Fees: Here's What You're Paying For

    It is important to understand mutual funds fees so that you know what you are paying and to whom, and how that impacts your portfolio returns.
  4. Investing

    Consider These Fees When Evaluating Mutual Funds

    The best way to evaluate a mutual fund is by digging a bit deeper into the fees charged.
  5. Investing

    Trading Mutual Funds For Beginners

    Learn about the basics of trading and investing in mutual funds. Understand how the fees charged by mutual funds can impact the performance of an investment.
  6. Financial Advisor

    How Mutual Fund Companies Make Money

    Read about the many different kinds of fees and sales charges mutual fund companies can use to generate revenue from those who invest in their shares.
  7. Financial Advisor

    Pay Attention To Your Fund’s Expense Ratio

    Despite trends indicating an overall decrease in fees across many fund categories, investors should still pay attention to expense ratios: even small differences in fees can have a significant ...
  8. Investing

    4 Expensive Mutual Fund Mistakes to Avoid

    Mutual funds are a good way to balance your asset allocation but there some potentially expensive pitfalls investors need to be aware of.
Frequently Asked Questions
  1. I'm about to retire. If I pay off my mortgage with after-tax money I have saved, I can save 6.5%. Should I do this?

    Only you and your financial advisor, family, accountant, etc. can answer the "should I?" question because there are many ...
  2. My wife and I both converted our Traditional IRAs to Roth IRAs over a decade ago and have invested the maximum allowed each year since. We're buying our first home soon. Do we both qualify for one-time, tax-free, $10,000 distributions?

    You and your spouse each qualify for a penalty-free distribution of up to $10,000 for the purchase, acquisition or construction ...
  3. Is a Thrift Savings Plan (TSP) a qualified retirement plan?

    Take advantage of the government's retirement plan for employees with the Thrift Savings Plan. As with a 401(k), contributions ...
  4. Who manages the assets in a Roth 401(k) account?

    Learn how to personally manage the assets in your Roth 401(k) plan and determine the best options available to help meet ...
Trading Center