An informed investor knows where his money is going. For an investor in mutual funds, it is essential to understand the expenses of mutual funds. These expenses directly influence the returns and cannot be neglected.
The expenses of mutual funds are met from the capital invested in them. The ratio of the expenses associated with the operation of the mutual fund to the total assets of the fund is known as the “expense ratio.” It can vary from as low as 0.25% to 1.5%. In some actively managed funds it may be even 2%. The expense ratio is dependant on one more ratio “the turnover ratio”.
“The turnover rate” or the turnover ratio of a fund is the percentage of the fund’s portfolio that changes annually. A fund that buys and sells stocks more frequently obviously has higher expenses and thus a higher expense ratio.
The mutual fund expenses have three components:
The Investment Advisory Fee or The Management Fee: This is the money that goes to pay the salaries of the fund managers and other employees of the mutual funds.
Administrative Costs: Administrative costs are the costs associated with the daily activities of the fund. These include stationery costs, costs of maintaining customer help lines and so on.
12b-1 Distribution Fee: The 12b-1 fee is the cost associated with the advertising, marketing and distribution of the mutual fund. This fee is just an additional cost which brings no actual benefit to the investor. It is advisable that an investor avoids funds with high 12b-1 fees.
The law in US puts a limit of 1% of assets as the limit for 12b-1 fees. Also not more than 0.25% of the assets can be paid to brokers as 12b-1 fees.
It is important for the investor to watch the expense ratio of the funds that he has invested in. The expense ratio indicates the amount of money that the fund withdraws from the funds assets every year to meet its expenses. More the expenses of the fund, lower will be the returns to the investor.
However it is also essential to keep the performance of the funds in mind too. A fund may have higher expense ratio, but a better performance can more than compensate higher expenses. For example, a fund having expense ratio 2% and giving 15% returns is better than a fund having 0.5% expense ratio and giving 5% return.
Investors should note: It is not sensible to compare returns of funds in different risk classes. Returns of different classes of funds are dependant on the risks that the fund takes to achieve those returns. An equity fund always carries a greater risk than a debt fund. Similarly an index fund that invests only in relatively stable and thus less risky index stocks, cannot be compared with a fund that invests in small companies whose stocks are volatile and carry greater risk.
Avoiding funds with high expense ratio is a good idea for the new investor. The past performance of a fund may or may not be repeated, but expenses usually do not vary much and will certainly reduce returns in future too.