Management Fees vs. Management Expense Ratio: An Overview
Mutual funds are a great way to invest in the stock and bond markets without incurring specific stock risk. A team of investment professionals manage these funds and can provide 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. Mutual fund expenses are a critical component in deciding whether to invest in a fund.
Fees associated with a mutual fund include sales charges as well as other transaction fees, account fees, and fund expenses. Fund expenses include 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.
- The management fee is often used as the key determinant when making an investment decision.
- The MER is an even broader measure of how expensive the fund is to the investor.
- There are instances when the MER may be lower than the management fee.
Mutual funds charge management fees to cover their operating costs, such as the cost of hiring and retaining investment advisors who manage funds' investment portfolios and any other management fees not included in the other expenses category. Management fees are commonly referred to as maintenance fees.
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, legal, auditing, customer service, office supplies, and filing 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. The cost of hiring managers is the largest component of management fees; it can be between 0.5% and 1% of the fund's assets under management (AUM). Even though this percentage amount seems small, the absolute amount is in millions of U.S. dollars for a mutual fund with $1 billion of AUM. Depending on the reputation of management, highly skilled investment advisors can command fees that push a fund's overall expense ratio quite high.
Management Expense Ratio
Notably, 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 can label MER in 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
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, the company 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).
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, the MER can often be higher than the management fee.
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 a low interest rate environment. When interest rates are low, money market funds see expenses that exceed returns, so the fund companies often absorb 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.