An informed investor knows where his money is going. For a mutual fund investor, understanding mutual fund expenses is imperative. These expenses directly affect income and cannot be ignored.
Mutual fund expenses are covered by the capital invested in them. The relationship between the expenses associated with operating the mutual fund and the fund’s total assets is known as the “expense ratio.” It can range from 0.25% to 1.5%. In some actively managed funds, it can go up to 2%. The expense ratio depends on another ratio: the “turnover”.
The fund ‘turnover’ or turnover rate is the percentage of a fund’s portfolio that changes annually. Obviously, a fund that buys and sells stocks more frequently has higher payouts, and therefore a higher expense ratio.
Mutual fund expenses have three components:
Investment Advisory Fee or Administration Fee – This is money that goes to pay the salaries of fund managers and other mutual fund employees.
Administrative costs: Administrative costs are the costs associated with the daily activities of the fund. These include stationery costs, maintenance costs for customer help lines, etc.
12b-1 Distribution Fee: The 12b-1 Fee is the cost associated with advertising, marketing, and distributing the mutual fund. These fees are just an additional cost that is not really beneficial to the investor. It is recommended that the investor avoid funds with a high rate of 12b-1.
In the United States, the law sets an asset limit of 1% as a maximum of 12b-1 rates. Also, no more than 0.25% of assets can be paid to brokers as a 12b-1 fee.
It is important that an investor be aware of the ratio of expenses for the money invested. The expense ratio indicates how much money the fund withdraws from the fund’s assets each year to cover its expenses. The higher the fund’s expenses, the lower the investor’s return.
However, you also need to take into account the performance of the funds. The fund may have a higher expense ratio, but better performance can offset the higher expenses. For example, a fund with an expense ratio of 2% and offers 15% more return than a fund with a 0.5% expense ratio and a return of 5%.
Investors should note: It is unreasonable to compare fund returns across different risk categories. The returns of the different classes of funds depend on the risks that the fund takes to achieve those returns. The equity fund always carries more risk than the debt fund. Likewise, an index fund that invests only in indexed stocks that are relatively stable and therefore less risky cannot be compared to a fund that invests in small companies whose stocks are volatile and carry higher risk.
Avoiding money with a high expense ratio is a good idea for a new investor. The fund’s past performance may or may not double, but expenses generally don’t differ much and will certainly reduce returns in the future as well.