The annual expense ratio is a fund's recurring management fees as a percentage of a its 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. It is taken out of the fund's assets, which lowers the return to investors. An expense ratio of 0.5% means that each year 0.5% of the fund's total assets are 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. Funds have also used 12b-1 fees 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. No-load fund families often use the 12b-1 fee (0.25%) to purchase "shelf space" on a brokerage's mutual fund "supermarket" platform. The platform then sells these funds as "no transaction fee" funds, but sells no-load funds not paying the fee with an added sales purchase fee.
There are different kinds of expense ratios that you 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. As a result, it is to some degree 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. The fund's NAV reflects fund expenses.[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 below shows 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, you 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 different names in other countries. For example:
- Canada: The expense ratio is known as the 'Management Expense Ratio (MER)'.
- Europe and the UK: 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 calculate a blended expense ratio across a portfolio, calculate 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
- Mutual funds: additional costs
- Purchase fee
- Redemption fee
- Effect of Expenses on a Portfolio (viewable and downloadable spreadsheet}
- How much do you lose to annual fees after many years?
- Mutual Fund Fees Calculator, by Bankrate.com. View the impact of fees and operating expenses on the investment fund over time.