Understanding what is Expense Ratio
Expense Ratio is an imperative estimate used by the market to find out if a fund or business is profitable and competent. In regards to a mutual fund, this is a yearly estimate which demonstrates what percent of fund’s value is used by management expenses. A mutual fund expense ratio is a glimpse at how much amount is required for a company to keep the investment running. It is reflective of the operating costs and directly impacts the returns that a fund generates, and how much money an investor will be able to keep in their pockets.
These ratios vary from fund to fund. Mutual fund expense ratios can be used to determine the fund’s performance and return. There is a huge difference between a fund with 0.3% expense ratio and the one with a 2% expense ratio.
How to calculate Mutual Fund Expense Ratio
The total expense ratio of a mutual fund is calculated by dividing the fund’s total operating expenses by the average value of all its shares. The expenses paid by a fund majorly consist of the fee charged by the manager. Other expenses include rent, operating costs, legal and accounting fees, record keeping, mailing, and other administrative costs. Some funds may even include advertising fees (12B-1) in their expenses.
Regardless of any profit or loss from the investment, these expenses are charged to the investors. These expenses are added together and then divided by the standard worth of the fund assets to calculate the expense ratio. This percent of the total expenditure is then subtracted from the fund value to calculate the income of the investor. As expense ratio may vary, investors must pay attention to the ratio of the mutual fund they are interested in. This will help them know whether the total cost of the mutual fund will be too much for them to handle.
How Mutual Fund Companies adjust their Expense Ratio?
As in investor, it’s impossible for you to not pay any and all fees while investing, but companies are able to control the range of their expense ratio by managing their fund. The more actively a fund is managed, higher will be the manager’s fee. Depending on whether they have 12B-1 fees, how much company spends on advertising and promotion also affect the level of expenses. Other factors that influence the cost of the fund are staff size and office location.
Smaller funds or those dedicated to a specialized sector of the industry have been known to have an expense ratio of 2% or higher, whereas less actively managed investments like index funds could have expense rates as low as 0.2%.
Two things that are not considered while computing expense ratio are sales charges (loads) and redemption fees. These are directly paid by the investors, so investors need to ensure what those costs will be.