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What is 'Expense Ratio'

The expense ratio, also known as the management expense ratio (MER), measures how much of a fund's assets are used for administrative and other operating expenses. An expense ratio is determined by dividing a fund's operating expenses by the average dollar value of its assets under management (AUM). Operating expenses reduce the fund's assets, thereby reducing the return to investors.

BREAKING DOWN 'Expense Ratio'

Operating expenses vary according to the fund or stock; however, the expenses within the fund remain relatively stable.  For example, a fund with low expenses will generally continue to have low expenses. 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 are 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

Most expenses within a fund are variable; however, the variable expenses are fixed within the fund.  For example, a fee consuming .5% of the fund's assets will always consume .5% of the assets regardless of how it varies.  In addition to the management fees associated with a fund, some funds have an advertising and promotion expense referred to as a 12b-1 fee, which is included in operating expenses. 12b-f fees within a fund cannot exceed 1% (.75% allocated to distribution and .25% allocated to shareholder servicing) according to FINRA rules.

A fund's trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio. Costs not included in operating expenses are loads, contingent deferred sales charges (CDSC), and redemption fees, which, if applicable, 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, which are passively managed funds, typically carry very low expense ratios. The managers of these funds are generally replicating a given index; therefore, the associated management fees are lower due to the lack of active management as with the funds they mirror. Actively managed funds employ teams of research analysts examining companies as potential investments. Those additional costs are 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 0.04% annually. At this level, investors are charged just $4 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 0.74%.

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