The annual expense ratio represents recurring management fees as a percentage of a mutual fund's assets. It shows what it costs the investment firm to operate the fund. The expense ratio represents the percentage of the fund's assets that go purely toward the expense of the daily operation of the fund. The fund's expense ratio is taken out of the fund's assets and lowers its return to investors. An expense ratio of 0.5% per annum means that each year 0.5% of the fund's total assets will be used to cover expenses.
The expense ratio does not include brokerage costs a mutual fund incurs when purchasing and redeeming securities, nor does it include any sales charges (front-end loads or deferred sales charges) associated with buying and selling the fund.
The major parts of the expense ratio are the management fee and the administrative cost. In the US, some funds also charge an additional fee, known as 12b-1, to cover marketing and distribution costs.
- The investment advisory fee or management fee is the money used to pay the manager of the mutual fund.
- Administrative costs are the costs of recordkeeping, mailings, maintaining a customer service line, etc. These are costs that all funds have, but they vary in size from fund to fund.
- Some funds also charge a 12b-1 fee. The 12b-1 fee gets its name from the section in the Investment Company Act of 1940  that allows a mutual fund to pay distribution and marketing expenses out of the fund's assets. The original intent of a 12b-1 fee was to help market the mutual fund so that its assets would increase. A 12b-1 fee has also been used as a hidden way to pay brokers for using the fund. The SEC has limited the 12b-1 fee to 1% annually with maximum of 0.25% going to brokers. The 12b-1 fee (0.25%) is also often used by no-load fund families to purchase "shelf space" on a brokerage's mutual fund "supermarket" platform. These funds are then sold as "no transaction fee" funds; no-load funds not paying the fee are sold by the supermarkets with an added sales purchase fee.
There are different kinds of expense ratios that investors should watch out for.
- Prospectus Gross Expense Ratio - Gross Expense Ratio represents the total gross expenses divided by the fund's average net assets. In some instances, a mutual fund might "waive" a portion of its costs. Some fee waivers have an expiration date; other waivers are in place indefinitely. If the gross expense ratio is not equal to the net expense ratio, the gross expense ratio portrays the fund's expenses had the fund not waived a portion, or all, of its fees. Thus, to some degree, it is an indication of fee contracts.
- Prospectus Net Expense Ratio - The percentage of fund assets used to pay for operating expenses and management fees, including 12b-1 fees, administrative fees, and all other asset-based costs incurred by the fund, Fund expenses are reflected in the fund's NAV.[note 2]
- Audited Net Expense Ratio - This expense ratio is pulled directly from the fund's annual report. It reflects the percentage of fund assets paid for operating expenses and management fees, including 12b-1 fees, administrative fees, and all other asset-based costs incurred by the fund. Fund expenses are reflected in the fund's NAV.
The table sums up where to look for the different expense ratios.
|Prospectus Net ER||Audited Net ER||Prospectus Gross ER|
|Data Source||Fund Prospectus||Audited Annual Report||Fund Prospectus|
|Time period||Upcoming fiscal year||Previous fiscal year||Upcoming fiscal year|
Expense ratios found on websites usually include management fees, administrative fees, marketing and distribution fees, operating costs, and all other asset-based costs incurred by the fund. However, one should check the website definitions to be sure.[note 3] It is sometimes referred to as a Total Expense Ratio.
The expense ratio familiar to American investors has many different iterations on global markets.
- Canada: The expense ratio is known as the Management Expense Ratio (MER).
- Europe and the United Kingdom: The expense ratio is known as the Ongoing Charges Figure (OCF) or the Total Expense Ratio (TER).
- Australia: The expense ratio is known as Management Costs.
Blended expense ratio
To compute a blended expense ratio across a portfolio, compute the expenses for each fund, sum the expenses, and then divide that sum by your total balance, as shown below:
(View Google Spreadsheet in browser, then File --> Download as to download the file.)
Note: If the spreadsheet is blank, select a different sheet, then back to that sheet. The image will be refreshed.
In the example above, the blended expense ratio of 0.41% is calculated by dividing $32.40 (the sum of the expenses) by $8,000 (the sum of the balances).
- Results are simulated. The saving phase simulates a participant with a salary of $45,000 at age 25, linearly increasing to $85,000 by age 65, making yearly contributions of 6% of salary at age 25, increasing by 0.5% per year to a maximum of 10% and with a 50% company matching contribution up to the first 6% of salary. In retirement, $63,750 (75% of final salary) is deducted at the beginning of each year. The blue-shaded area shows ending savings with an after cost investment return of 9% assumed at age 25, linearly decreasing to 6% at age 80 and remaining constant thereafter. Inflation is assumed to be a constant 3%. The tan-shaded area assumes 1% greater return each year due to reducing the costs of investment by 1%. All amounts are in present-day dollars. Source: AllianceBernstein, Target-Date Retirement Funds: A Blueprint for Effective Portfolio Construction, as presented to the DOL/SEC Hearing On Target Date Funds And Similar Investment Options, October 2005.
- Some mutual funds, known as fund of funds hold mutual funds as the portfolio investment. Since January 2007 a fund of funds is required to report an Acquired Fund Fee that shows the operating expenses of the underlying funds. The expense ratio for a fund of funds will include this acquired fund fee plus any additional management fees the fund incurs.
- Definitions from Morningstar are here, Vanguard's are here, Fidelity's are here - Fidelity's website reports both gross and net ratios.
- Mutual funds: additional costs
- Purchase fee
- Redemption fee
- Effect of Expenses on a Portfolio (viewable and downloadable spreadsheet}
- Mutual Fund Fees Calculator, by Bankrate.com. View the impact of fees and operating expenses on the investment fund over time.