The expense ratio of a stock or asset fund is the total percentage of fund
assets used for administrative, management, advertising, and all other
expenses. An expense ratio of 1% per annum means that each year 1% of the
fund's total assets will be used to cover expenses. The expense ratio does
not include sales loads or brokerage commissions.
Expense ratios are important to consider when choosing a fund, as they can
significantly affect returns. Factors influencing the expense ratio include
the size of the fund, sales charges, and the management style of the fund. A
typical annual expense ratio for a U.S. domestic stock fund is about 1%,
although some passively managed funds have significantly lower ratios.
One notable component of the expense ratio of U.S. funds is the "12b-1 fee",
which represents expenses used for advertising and promotion of the fund.
12b-1 fees are generally limited to a maximum of 1.00% per year under
Financial Industry Regulatory Authority Rules.
Waivers, reimbursements & recoupments Some funds will execute "waiver or
reimbursement agreements" with the fund's adviser or other service
providers, especially when a fund is new and expenses tend to be higher. These
agreements generally reduce expenses to some pre-determined level or by some
pre-determined amount. Sometimes, these waiver/reimbursement amounts must be
repaid by the fund during a period that generally cannot exceed 3 years from the
year in which the original expense was incurred. If a recoupment plan is in
effect, the effect may be to require future shareholders to absorb expenses
of the fund incurred during prior years. It is calculated by operating expenses.
Changes in expense ratio Generally, unlike past performance,
expenses are predictable. Funds with high expenses ratios tend to continue to
have high expenses ratios. An investor can examine a fund's "Financial
Highlights" which is contained in both the periodic financial reports and the
fund's prospectus, and determine a fund's expense ratio over the last five
years. It is very hard for a fund to significantly lower its expense ratio
once it has had a few years of operational history.
This is because funds have both fixed and variable expenses, but most expenses
are variable. Variable costs are fixed on a percentage basis. For example,
assuming there are no breakpoints, a .75% management fee will always consume
.75% of fund assets, regardless of any increase in assets under management. The
total management fee will vary based on the assets under management, but it will
always be .75% of assets. Fixed costs vary on a percentage basis
because the lump sum rent/audit amount as a percentage will vary depending on
the amount of assets a fund has acquired. Thus, most of a fund's
expenses behave as a variable expense and thus, are a constant fixed
percentage of fund assets. It is, therefore, very hard for a fund to
significantly reduce its expense ratio after it has some history. Thus, if an
investor buys a fund with a high expense ratio that has some history, he/she
should not expect any significant reduction.
Expenses matter relative to investment type
There are 3 broad investment categories for mutual funds. This is an
over-simplification, but is adequate to explain the effect of expenses. In an
equity fund where the historical gross return might be 9%, a 1% expense ratio
will consume approximately 11% of the investor's return. In a bond fund where
the historical gross return might be 8%, a 1% expense ratio will consume
approximately 12.5% of the investor's return. In a money market fund where the
historical gross return might be 5%, a 1% expense ratio will consume
approximately 20% of the investor's historical total return. Thus, an
investor must consider a fund's expense ratio as it relates to the type of
investments a fund will hold. Other uses
The term is also widely used among finance and accounting professionals to
demonstrate the profitability and viability of the operations of a
business. In this context, the expense ratio shows the percentage of an
operation's gross revenues that is being allocated to the expenses related to
running the operation. Business managers who use profit and loss statements to
draft business plans find expense ratios to be very useful indices in producing
forecasts, and determining where cost cutting and revenue maximization
opportunities exist. References
See also Total expense ratio