A:

A mutual fund's expense ratio is very important to investors because fund operating and management fees can have a large impact on net profitability. The expense ratio for a fund is calculated by dividing the total dollar value of fund assets by the total amount of fund fees, both management fees and operating expenses, charged to investors in the fund.

Expense ratios for mutual funds commonly vary between 0.1% and 2.5%. Average ratios for index funds are significantly lower than for actively managed portfolio funds, usually no more than approximately 0.25%. Expense ratios for actively managed funds most commonly fall in the range of 0.75% to 1.25%, but some funds have much higher expense ratios.

Most investors do not realize the significant impact of a seemingly small percentage difference in mutual fund expense ratios. An example easily demonstrates that even a relatively small difference in the mutual fund fees percentage has a significant effect on net investment profits.

Consider two mutual funds, both generating an average annual investment return of 5%, with one fund charging fees of 1% and the other charging total fees of 2%. The single percentage point difference does not immediately seem significant to most investors, but the fee amount is a percentage of profits, not just in relation to the total dollar value of investment in the fund.

For example, assume two investors begin the year with respective $100,000 investments in the 1% and 2% expense ratio funds, and each fund generates a 5% return on investment before fees are deducted. The investor paying 1% in fees has $1,000, or 1% of $100,000, of his $5,000 profit taken in fees because the fee is not 1% of profits but rather 1% of assets. The investor paying 2% in fees pays fees equaling $2,000 of his $5,000 profit. Thus, the small 1% difference in expense ratios translates to a whopping 10% difference in net profits.

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