When you buy a mutual fund, you're hiring the investment know-how of a professional money manager. Along with your fellow fund investors, you're also paying to keep the lights on at the fund's offices, cover marketing costs and fund employee salaries. All of these costs are reflected in a fund's expense ratio. Since the expense ratio is a drag on fund performance, buying funds that control costs can improve your return in the long run.
An expense ratio is an annual fee charged to all shareholders of a particular mutual fund. It's expressed as a percentage of assets. For example, if a fund has an expense ratio of 1.1 percent, then $11 of every $1,000 is taken out every year by the fund company to pay for various operating expenses. Management fees, administrative fees and other costs of running the fund comprise the expense ratio. The larger a fund grows, the lower the expense ratio tends to be, as those costs are spread out among a larger asset base.
Effect on Performance
Mutual fund performance is based on the net profits a fund can provide shareholders. Net profit is based on investment gains less expenses. The larger a fund's expense ratio, the more it reduces shareholder returns, since the money used to pay for the fund's expenses comes directly out of the fund's assets. When a fund company reports mutual fund net returns, that figure reflects the deduction of the expense ratio. Over time, an expense ratio even a few tenths of a percentage point higher can result in a substantial drag on investor returns.
In addition to annual expenses, many mutual funds have added costs in the form of sales charges. Class A shares can cost investors 5 percent or more of their investment to buy shares in a fund, while Class B shares can cost the same amount if you sell a fund. Class C shares charge higher annual expenses every year, over and above the costs included in the expense ratio. All of these fees reduce the overall return you earn from a mutual fund. However, unlike expense ratios, these charges do not reduce reported investment returns.
A fund's expense ratio can be an important factor in your investment decision. However, it shouldn't be the sole reason whether or not you buy a fund. Some funds with higher expense ratios perform quite well. At the end of the day, it's better to have a fund that makes a lot of money than one that loses money, even if it has higher expenses. All other things being equal, you'd want to pick the fund with the lower expense ratio; however, all other things are rarely equal. Your own investment objectives, risk tolerance and intended time horizon should play an important role in developing your mutual fund strategy.
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.