The discussion of mutual fund expenses tends to become a hot topic when the experts start discussing fund selection. Expenses of a fund are important. But because funds report results after taking expenses into account, you might not be able to verify the differences produced by a higher or lower expense ratio.
Mutual Fund Expenses
A mutual fund publishes its expenses in a prospectus and on its Web pages. The expense ratio is stated as an annual percentage of the total assets in the fund. A fund's expenses include portfolio management fees, general operating costs and marketing expenses. Expense ratios range from less than 0.10 percent for large index funds to more than 2 percent for smaller funds that have high expenses.
Returns Net of Expenses
The investment return reported by a mutual fund is always calculated net of expenses. If a fund reports an annual gain of 10 percent, investors receive 10 percent on their money. From a reported return point of view, it does not matter whether the fund had a 0.5 percent expense ratio or a 2.5 percent ratio. To earn that 10 percent for investors, the low-cost fund manager had to earn 10.5 percent on the portfolio. But the more expensive fund's portfolio generated a 12.5 percent gross return to pay investors 10 percent.
Comparing Fund Expenses
Although each mutual fund has its own investment style and objectives, it is also important to compare the expenses of different funds. You should have a compelling reason to pick a higher-expense fund over a similar mutual fund that has a lower expense ratio. The Securities and Exchange Commission's website notes that although higher-expense funds might outperform, a small difference in the expense percentage can have a significant effect over a multiyear period.
Load Fund Return Reporting
Mutual funds that charge a sales load provide two sets of return results. The net asset value -- NAV -- returns are the results net of expenses, but not including any sales charge paid when the fund was purchased. The fund will also report results including the effect of paying the full sales charge. This effect diminishes as the reporting period gets longer. For example, a 6 percent sales load reduces the fund return by the full 6 percent over one year, but the load lowers the annual return by just 0.6 percent over 10 years.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.