When you buy shares in a mutual fund, the expense ratio is what you pay for the management and operating expenses of the fund. The expense ratio decreases the fund’s performance and is included in the fund’s average return percentages. It is important to note that not all fees associated with mutual funds are included in the expense ratio, however.
Expense ratios are expressed as a percentage and you can find them in the mutual fund’s prospectus. The expense ratio is a percentage of the fund’s net asset value (NAV) that is deducted for fees such as 12-b1 fees, which cover the cost of promoting and marketing the fund, fees paid to the fund manager and administrative costs. If a mutual fund offers different classes of fund shares, expense ratios can vary depending on the class of fund shares you purchase.
Effect on Returns
Expense ratio fees are deducted from the NAV of the fund whether the fund has gained or lost value during the year. For instance, say you buy shares in a mutual fund that has an expense ratio of 1 percent. At the end of year one, the fund returns 10 percent overall. However, once the fund deducts the expense ratio, the fund’s return is actually 9 percent. The fund reports the 9 percent return in its prospectus and to the public. Say the same fund had a bad year and had a loss of 1 percent. Expenses are paid regardless, so the loss is actually 2 percent.
Other expenses that affect the overall return of a mutual fund are the costs incurred when the manager buys, sells and trades assets within the fund’s portfolio. Front-end and back-end sales charges, referred to as front-end and back-end loads, are not included in the mutual fund’s expense ratio. You pay the sales charge on a front-end load mutual fund when you purchase fund shares and you pay the sales charges on a back-end load mutual fund when you redeem your shares. Not all mutual funds have loads.
You should consider the expense ratio, as well as other expenses such as sales loads, when assessing the cost versus the potential return for mutual fund shares you are considering purchasing. Other fees you need to consider are purchase and redemption fees, which are additional fees mutual funds may charge when you buy and redeem your shares. Purchase and redemption fees are not the same as front and back-end loads. Typically, the higher a mutual fund’s fees, the more it negatively affects the fund’s overall performance.