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.

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