May 7, 2010
Mutual Fund Expenses Explained
IconMutual Fund Expenses Explained by Gary Foreman Is your mutual fund management company getting rich whileyou're not? You know that they make money by managing some ofyours. But are they charging you too much? How can you tell?Let's answer some of the most common questions about mutualfund expenses. What are operating expenses? They'll include the payrollfor investment analysts, phone bills, rents for office spaceand the cost of printing and mailing your statements.Basically, it's the cost of managing your money. One notableexception is the commission that the fund pays to buy and sellsecurities. That's not included under operating expenses. It'sconsidered a 'transaction expense' in most cases. How do you calculate expense ratio for a specific fund?The math is pretty simple. Just take the operating expenses anddivide them by the average assets. Both figures will beavailable in the prospectus or quarterly report. For instance, afund with $10 million in assets and expenses of $100,000 wouldhave an expense ratio of 1.0%. How much is a 'reasonable' amount to pay for fundexpenses? That depends on two things. First, how hard is it tomanage the money and, secondly, how aggressive your managersare. Let's take two simple examples. First, consider a fund thatbuys US Treasury bonds and plans to hold them to maturity.There's not much research required so the expenses should below. In 1996 the average expense for a government bond fund was1.02%. Compare that to managing a long-term growth stock fund.You'll want your analyst to do a good job in finding the nextMicrosoft. That takes time and effort. And the average cost ofmanaging a growth fund was 1.42% in '96. As you would expect,the cost to manage international funds or find small emergingcompanies is even greater. Can higher expenses 'buy' better managers? Sometimes.The most talented managers should make more. What you reallywant to know is if the extra expense is worth it. The best wayto see if a fund really deserved a higher expense ratio is tosee how they've performed in direct comparison to other fundsand the market. If they've done a better job on a regular basis,the higher expenses shouldn't bother you. Conversely, if theyhaven't outperformed, find another fund. How am I charged with the expenses? Is it on my quarterlystatement? Unfortunately, you'll have to do a little bit ofdigging to find out how much of your money the fund spent. It'snot found on your statement. You'll need to go to the fund'sincome statement in the quarterly report to find the answer.Most people toss the report without looking at it. A number of industry 'watchdogs' are pushing to have fundexpenses shown on your fund statement. They argue that ifpeople knew how much they were spending on expenses there wouldbe more pressure to control the cost. Fund managers counterthat the increased cost of collecting and reporting thatinformation would only increase the expenses. How do expenses affect my earnings? They're subtractedbefore you see your earnings. If a fund earns 10% and theexpenses are 1.2%, you'll see a return of 8.8% (10.0 minus 1.2equals 8.8). That's not so bad when markets are going up, butremember that the expenses go on even if a fund is losingmoney. A half-percent difference in expenses can seem huge ifyour fund is only making a couple of percent. Are 'big funds' less expensive than smaller ones? Yes,but not by as much as you'd think. Obviously, it doesn't costtwice as much to manage a fund that's twice as big. But youneed to remember that the mutual fund companies want to make aprofit, too. All of the savings of a big fund don't come backto you. Some of that savings goes to the fund company asadditional profits. What should I look for when I consider fund expenses?Look for two things. First, how does the fund's expense ratiocompare to other similar funds? If it's higher, check to seeif it's justified by performance. Don't forget to make surethat the manager that produced the past performance is stillmanaging the fund. Second, if the fund is part of a family, take a look atthe average family expenses, especially if you're buying a loador 12b-1 fund. You may want to switch to a different fundwithin the family some day. That could be less attractive ifthe whole family has higher expense ratios than the average.And there's quite a bit of difference in average familyexpenses. Some have a ratio of less than 3/4 of a percent andmany others are over 1.5%. One final thought. You do need to keep all this inperspective. In some ways it's the same as deciding to orderpizza. How much time and money would it take you to make thepizza? Is it a good value? Unless you're really into trackingand researching stocks, you may be getting a pretty good dealfor your one percent or so. That doesn't mean that youshouldn't consider expenses in picking funds; just rememberthat it's only part of the equation. Gary Foreman is a former Certified Financial Planner who currents publishes The Dollar Stretcher website Permission granted for use on

Posted by Staff at 1:29 AM