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.

Related Reading:


Commission & Redemption Fees

Related Articles
  1. Investing

    12b-1: Understanding Mutual Fund Fees

    Many mutual funds charge investors a 12b-1 fee to pay for marketing and promotion expenses.
  2. Investing

    Mutual Fund Fees: Here's What You're Paying For

    It is important to understand mutual funds fees so that you know what you are paying and to whom, and how that impacts your portfolio returns.
  3. Investing

    Consider These Fees When Evaluating Mutual Funds

    The best way to evaluate a mutual fund is by digging a bit deeper into the fees charged.
  4. Financial Advisor

    How Mutual Fund Companies Make Money

    Read about the many different kinds of fees and sales charges mutual fund companies can use to generate revenue from those who invest in their shares.
  5. Financial Advisor

    Pay Attention To Your Fund’s Expense Ratio

    Despite trends indicating an overall decrease in fees across many fund categories, investors should still pay attention to expense ratios: even small differences in fees can have a significant ...
  6. Investing

    4 Expensive Mutual Fund Mistakes to Avoid

    Mutual funds are a good way to balance your asset allocation but there some potentially expensive pitfalls investors need to be aware of.
  7. Investing

    A Guide For Picking Long Term Mutual Funds

    Learn about considerations for investors when buying shares in a mutual fund for a long-term investment, including fees, type of management and portfolio goals.
Frequently Asked Questions
  1. Why Do Most of My Mortgage Payments Start Out as Interest?

    Fear not: Over the life of the mortgage, the portions of interest to principal will change.
  2. What is the difference between secured and unsecured debts?

    The differences between secured and unsecured debt, and how banks buffer risks associated with each type of loan through ...
  3. How Many Times has Warren Buffett Been Married?

    Warren Buffett has been married twice in his life, but the circumstances surrounding the marriages were unconventional.
  4. What's the smallest number of shares of stock that I can buy?

    Many people would say the smallest number of shares an investor can purchase is one, but the real answer is not as straightforward. ...
Trading Center