The operation of a mutual fund involves costs, such as operating expenses, which are not directly related to investor transactions. The largest component of operating expenses is a fee paid to the mutual fund's manager. Other expenses include record-keeping, custodial services, legal expenses, taxes, and accounting and auditing fees. Some funds also have a 12b-1 fee, which is a marketing, advertising and distribution services fee. The fees are charged regardless of fund performance.
The expense ratio refers to the percentage of total assets required to operate a fund. The percentage is determined annually, by dividing a fund's operating expenses by the average dollar value of assets under fund management. The fees resulting from the buying and selling of fund assets are not included. According to Bloomberg, the average expense ratio for actively managed mutual funds is 1.43 percent per year. In turn, equity- and bond-index funds charge average fees of 0.14 and 0.13 percent respectively. A 1.43 percent per annum expense ratio means that a fund must use 1.43 percent of a fund's total assets to cover operating costs. Operating expenses decrease the total value of the mutual fund's assets, which reduces the return to fund investors. Therefore, the lower the ratio, the better for investors.
Significance of Expense Ratio
Investors consider a firm with strong asset performance – as indicated by relatively low operating expenses -- as potentially a good investment. A lower expense ratio means more efficient use of the fund’s assets in earning the investors’ return, lower operating costs and a higher return for investors, all other things being equal. If one fund earns the same return as another fund using an equal amount of assets with less expense, the first fund is more efficient than the second fund. In turn, the first fund is perceived by investors to perform better than its competitors. In this way, investors rely on the expense ratio to compare a fund’s performance from one period to another or against the performance of its competitors.
Application of Expense Ratio
The average expense ratio for actively managed mutual funds is 1.43 percent per year versus 0.14 and 0.13 percent respectively for equity index and bond index funds. So if the gross return for three funds is 6 percent, operating expenses consume 23.8 percent of an actively managed fund's return, 2.3 percent of the equity index fund's return and 2.2 percent of the bond index fund's return. However, it is important to review each of the elements that make up the operating expenses, such as the management fee expense, rather than evaluating the expense ratio alone. In this case, the actively managed mutual fund must out-perform the index funds by at least 21.5 percent for an investment in this fund to be a good one.
Research Expense Ratios
The Securities and Exchange Commission requires each mutual fund to create a prospectus, which is a disclosure document and contract between the fund and the investor. The "Cost of the Fund" section of the prospectus describes a fund's fees and expenses.
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