Image source: Getty Images.
Mutual funds and exchange-traded funds make it easy to build a diversified investment portfolio even if you only have modest amounts of money to invest. However, mutual funds and ETFs charge fees to provide their management services, and many of any given fund's costs are reflected in its mutual fund expense ratio. The expense ratio reflects the operating costs of running the mutual fund, including fees for asset management, administrative responsibilities, compliance, and other fixed overhead costs. In addition, the expense ratio includes any marketing fees the fund charges under SEC Rule 12b-1. The figure is expressed as an annual percentage, but shareholders bear the burden of expenses on an ongoing basis rather than at any set time. Moreover, some fund costs aren't included in the expense ratio.
What the mutual fund expense ratio means
The mutual fund expense ratio can give you a good idea of how much you'll pay in fees each year. For instance, an expense ratio of 1% means that for every $1,000 you have invested in a fund, the fund will collect $10 from your account to cover its costs. Note that you won't see this $10 deduction on your statement. Instead, it's simply taken directly from the fund assets, and so the reduction shows up in the form of a lower net asset value for fund shares than you'd otherwise see.
Sometimes, companies will report both a gross expense ratio and a net expense ratio. For some funds that use leverage as part of their investing strategy, gross expenses include the borrowing costs they incur. More commonly, the gross expense ratio reflects the fund's actual costs before granting a fee waiver, while the net figure includes the impact of fees that the management company chooses to waive.
In general, the lower the expense ratio, the better for investors. Every dollar that a fund company charges in expenses is one less dollar in your account, and the compounding impact of money you lose to fees can grow to a substantial sum over the course of your investing career. Typically, actively managed funds have higher expense ratios because of the higher management fees their managers charge. Index funds, which have minimal management needs, have much lower fees. The difference can be substantial, with many active funds charging 1% or more while some index funds charge 0.1% or less.
What the mutual fund expense ratio doesn't include
Many fund shareholders find it surprising that the expense ratio doesn't include every cost the fund incurs. Yet one two major fund costs don't make it into the expense ratio: brokerage expenses that the fund pays to buy and sell investments and sales loads and other charges the fund imposes on shareholders.
Not putting a sales load in the expense ratio makes a degree of sense. Many funds are no-load and don't have sales charges at all. Even for load funds, the amount of the sales load can differ between investors depending on how much they have to invest. Forcing a fund company to include as assumed sales load would be misleading for those who pay a different amount.
Brokerage costs, however, can be a substantial portion of a fund's expenses. Leaving them out has a disproportionately large impact on fees for actively managed funds with high rates of turnover. It consequently reduces the perceived benefit of passive strategies that index funds use, most of which involve relatively little turnover and relatively low trading costs.
Using the expense ratio to compare different mutual funds and ETFs can be a great way to ensure that you lose as little of your hard-earned returns as possible to investment costs. Those funds that cut their expense ratios to the bare minimum often make the best choices for those seeking high-quality investment options.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!
