One of the aspects of investing that is often over-shadowed by investment returns is the importance of expense ratios in mutual funds. These expenses can erode returns and are often misunderstood by investors. Expense ratios are the fees paid to the fund itself by investors like you and me. These fees are expressed as a percentage and go to cover the costs of running the fund.
The expense ratio of a mutual fund wraps several fees into one number making it somewhat easy to understand. The number is expressed as a percentage of assets under management. For example, if you own $10,000.00 of a mutual fund with a 1% expense ratio, your yearly costs would be $100.00. That $100.00 is used to pay the fund’s manager(s), administrative costs, and possible 12b-1 fees. 12b-1 fees are used for marketing, advertising, and the costs of selling the fund (commissions paid to brokers). Yes, part of the expenses you pay every year goes to advertise the fund, as well as compensate brokers who sell the fund and receive commissions. Now, not every fund carries a 12b-1 fee, and I strive to stay away from those that do!
There are two general types of mutual funds: Actively managed and passively managed. An actively managed fund is a fund who’s manager strives to outperform a market index. These funds, on average, have expense ratios in the 1.4% range. It’s higher for international funds and lower for fixed income funds. Passively managed funds are funds who’s manager strives to mimic or capture the returns of an index. These funds on average have much lower expense ratios. Why? Well, the guess work is taken away from the fund’s manager. If a fund’s job is to follow the S&P 500 index, the stock picking is already done. The fund doesn’t need to pay a fund manager to go out and find investment opportunities because the fund’s objective is set….replicate the S&P 500 index.
While the above paragraph may be a bit difficult to grasp, the understanding of expense ratios should not be. It’s very simple…..the higher the expense ratio, the more you pay!
Some funds may be worth the extra costs, but you should at least know what you are paying in expenses before you buy! Stay tuned for Part II, as I will explore an example and illustrate the affects of expense ratios on long-term returns.