Expense ratio

The expense ratio of a stock or asset fund is the total percentage of fund assets used for administrative, management, advertising (12b-1), 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.^[1] 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 (small funds often have higher ratios as they spread expenses among a smaller number of investors), 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 (such as index 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 (.75% distribution and .25% shareholder servicing) 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 (due to a small asset base). 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 (fixed & variable expenses)

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 (if the fund has five years of history). 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 (such as rent or an audit fee) 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 (equity, bond, and money market - in declining order of historical returns). 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 (1 divided by 9 is about 0.11 or 11%). 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^[2] 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 (i.e. income 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.^[3]

References

See also

• Total expense ratio