What is the expense ratio of a mutual fund?

Paul's Answer:

This is the amount of money, expressed as a percentage of a fund's total investments, that shareholders pay the fund company to operate the fund and manage the money. These expenses are taken out of current income. Expense ratios vary widely. Some are extremely low. Vanguard's Small Cap Index and Extended Market Index funds have expense ratios of 0.23 percent. But a few funds have expense ratios of 5 percent or more.

More typical is a range from 0.7 percent (for instance Fidelity Blue Chip Growth Fund) to 1.75 percent (for instance T. Rowe Price Emerging Markets Stock Fund).

In general, you'll find the lowest expense ratios at index funds, which require relatively little research and portfolio management. You'll find higher expense ratios at specialized funds such as small-cap international funds. Bond funds should have lower expense ratios than stock funds.

The management portion of the expense ratio is a fixed percentage, based on asset size of the fund, set in advance by the fund's management company. It is disclosed in a fund's prospectus. Many of a fund's costs are fixed; that is, they don't change much just because a fund attracts new shareholders and new assets. So in theory, the expense ratio should decline as a fund gets larger and has more shareholders to share the costs of operation. However, some funds keep their expense ratios higher than necessary, so as to enhance their profits.

Fund expenses also include the costs of bringing in assets and shareholders. These include costs for advertising, marketing, public relations, toll-free telephone numbers, promotional literature and the like. These are referred to as distribution expenses.

In a strictly no-load fund, distribution expenses are included in the expense ratio and paid by the management company. But some funds levy a separate charge for these expenses, called a 12b-1 fee. This charge is typically 0.75 percent to 1 percent of the fund's assets, but many funds charge smaller 12b-1 fees in the range of 0.25 percent.

In a load fund, a 12b-1 fee normally covers deferred commissions paid to salespersons. This cost provides no benefit to shareholders.

Shareholders get little value, if any, from paying high fees and expenses in a mutual fund. On the contrary, high expenses are a drag on returns. A skipper who dragged a bucket behind a sailboat would be unlikely to win a race. An investor who buys a mutual fund with high expenses is unlikely to achieve superior returns.

When you are comparing funds, compare similar ones. Don't expect an actively managed small-cap value fund to operate with the same low costs as an index fund. Likewise, don't buy an index fund that has a high expense ratio.

Unless it is essential that you have the advice of a salesperson who receives no other compensation from you, avoid load funds. If you are thinking of purchasing a load fund, consider a lower-cost no-load alternative. You can find such alternatives for 100 of the largest load funds in a unique feature called "Explode Loads" on our Web site.