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What is the 'Expense Ratio'

The expense ratio is a measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual calculation, where a fund's operating expenses are divided by the average dollar value of its assets under management (AUM). Operating expenses are taken out of a fund's assets and lower the return to a fund's investors. It is also known as the management expense ratio (MER).

BREAKING DOWN 'Expense Ratio'

Depending on the type of fund, operating expenses vary widely. The largest component of operating expenses is the fee paid to a fund's investment manager or advisor. Other costs include recordkeeping, custodial services, taxes, legal expenses, and accounting and auditing fees. Expenses that are charged by the fund as reflected in the fund's daily net asset value (NAV) and do not appear as a distinct charge to shareholders.

Components of an Expense Ratio

In addition to the management fees associated with a fund, some funds have a marketing cost referred to as a 12b-1 fee. This fee, if it exists, would also be included in operating expenses. A 12b-1 fee is charged by the fund to cover its distribution and marketing costs. A fund's 12b-1 fee can be as high as 1% annually, with 0.75% going to distribution and marketing expenses and 0.25% going to service fees.

A fund's trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio. Costs associated with mutual funds but not included in operating expenses are loads, contingent deferred sales charges (CDSC) and redemption fees, which, if they apply, are paid directly by fund investors.

Index Funds vs. Actively Managed Funds

The expense ratio of an index fund and an actively managed fund often differ significantly. Index funds typically carry very low expense ratios. The managers of these funds are simply replicating a given index, so there is no need to have a full management team on staff to populate the fund. Actively managed funds do, however, need to employ teams of research analysts examining companies as potential investments. Those additional costs get passed on to shareholders in the form of higher expense ratios.

The Vanguard S&P 500 ETF, an index fund that replicates the Standard & Poor's (S&P) 500 Index, has one of the lowest expense ratios in the industry at 0.05% annually. At this level, investors are charged just $5 per year for every $10,000 invested. The Fidelity Contrafund is one of the largest actively managed funds in the marketplace with an expense ratio of 0.71%.

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