Diversification is important. But if you only have a few hundred or thousand dollars to invest, it can be hard to invest in a range of companies. Even if you have enough money to buy a few shares of 10 or more companies, your trading costs can eat away at any gains. Investing in a mutual fund, however, allows you to pool your money with others and invest together.
Even so, investing your money this way isn’t without expense: A company has to manage the money in the mutual fund, and it passes on the costs of administering the mutual fund to you in the form of an expense ratio.
The mutual fund expense ratio is the percentage of a fund’s asset charged to investors as an annual fee for managing the fund. By understanding this expense and how it affects your returns, you can often make better decisions on which investments will best suit your needs and preferences.
- Mutual Fund Expense Ratio
- How Mutual Fund Expense Ratios Affect Returns
- Mutual Fund Fees
A mutual fund expense ratio compares how much the company charges investors as a percentage of the fund’s net assets. The expenses can include:
- Management fees
- Distribution fees
- Marketing fees
- Shareholder services fees
- Other expenses, such as legal and accounting fees
Many mutual funds classify distribution and marketing fees as 12b-1 fees. These fees get their name from the Securities and Exchange Commission rule that authorizes funds to levy such charges. These 12b-1 fees can also include shareholder service fees. These costs cover the dissemination of information to investors, as well as answering investor inquiries.
Moreover, investors should understand that the ratio above is a gross expense ratio. It does not include brokerage costs or sales costs. However, you may see something called a net expense ratio. The net expense ratio is the expense ratio charged. This accounts for fees that are waived, recovered, reimbursed or recouped by the advisor.
This is calculated by dividing total expenses by the value of average net assets. Funds charge this expense each year.
You won’t see the expenses taken out of your investment as a line item, because the expenses just reduce the value of the mutual fund. You can check the mutual fund’s prospectus to find the percentage you’re paying. In most cases, you can also find this information on the brokerage company’s website or by conducting a web search on the ticker symbol.
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Average mutual fund expense ratios depend on the type of mutual fund. On average, funds charge a 1.26% expense ratio every year in equity mutual funds.
For participants in 401(k) plans, however, these expense ratios fall to 0.41% on average. This can occur for a variety of reasons. Employers often share the administrative costs of these plans with their employees. Money in 401(k) plans also tends to be invested in lower-cost funds. Furthermore, federal law requires that plans must ensure reasonable service costs.
The mutual fund expense ratio reduces the return on your investment because the fees lower the value of your interests in the mutual fund. When expense ratios are higher, it’s harder for the fund to outperform the market as a whole. If one mutual fund charges you 1%, you will need a 1% return just to break even each year. Over time, these small differences can add up.
For example, Mutual Fund X charges 0.62%, and Mutual Fund Y charges 0.12%. If you invest $25,000 for 10 years, you will pay:
- $2,700 for Mutual Fund X
- $534 for Mutual Fund Y
This does not mean a high-fee mutual fund is always the wrong choice. However, that fund needs to generate returns that at least cover the cost of that higher fee. Hence, one way to evaluate the top-performing mutual funds is to subtract the total charges from the returns to determine the real rate of return for you.
Fund managers do not deduct fees related to the expense ratio from your account. Instead, they take this cost from fund assets. For this reason, you pay the expense ratio indirectly.
Mutual funds list their fees in terms of basis points. A basis point is one one-hundredth (0.01) of a percentage point. This means if a fund charges 100 basis points as an expense ratio, you will be charged 1% of your average net assets in fees. The expense ratio is typically listed in the prospectus as 1.00, which means if you invested $10,000 in such a fund, you would pay an expense ratio of $100.
Investors might assume that the best mutual funds charge the lowest expense ratios. However, expense ratios also hinge on many factors. One of these determinants involves how much work fund managers will have to put into managing the portfolio.
Actively-managed mutual funds will have higher fees than passive funds, like index funds. For this reason, you should not get caught up in looking at only the expense ratio. Different types of funds can have different expense ratios. For example, large-cap equities are widely traded, so expenses are generally low.
Mutual fund fees can also rise based on the type of investments. International mutual funds are one example. They typically involve higher fees as they could include currencies or stocks that trade on foreign exchanges.
Another type of mutual fund that may include higher fees is an alternative mutual fund. These funds pursue nontraditional investments such as global real estate, startups, commodities or derivatives. However, this type of fund brings with it a higher risk. Such investments are not appropriate for investing for retirement or other long-term needs.
See More: Types of Mutual Funds
You should also avoid confusing expense ratios with shareholder fees. Shareholder fees involve the buying or selling of these securities only. Most associate these with purchase or sales fees, sometimes called loads. But they can also include other transaction-related charges such as exchange fees or redemption fees. Some funds may also charge an account fee if holdings fall below a specified level. Should you see these fees on your statement, understand that they have no relation to the expense ratio.
For best results, always read the prospectus for any mutual fund you are considering to determine how much you will pay in fees when you’re deciding how to invest your money.
Click through to read more on how to invest your money in 2020.
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This article has been updated with additional reporting since its original publication.