The total expense ratio is the cost to an investor of the continued ownership of the shares of an investment fund such as a mutual fund, closed-end fund or exchange-traded fund. The expense ratio does not include any sales charge or redemption fee charged when buying or selling fund shares. Fund expenses are not an obvious, listed item on your fund or investment statements.
The Securities and Exchange Commission refers to the components of a fund's expense ratio as its annual operating expenses. The expenses consist of the fund management fees, distribution/services fees -- listed as 12b-1 fees -- and other fund expenses such as administrative and accounting expenses. The total of a fund's fees will be listed as a percentage of the fund's assets in the fund's prospectus and referred to as the total annual operating expenses. This percentage can also be referred to as the total expense ratio.
Expense Ratio Percentage
The expense ratio of a fund is expressed as a percentage of the fund's total assets. For example, one fund may have expenses of 1.5 percent while another may report 0.95 percent. Total expense ratios can range from less than one-quarter of a percent -- 0.25 percent -- to 2 percent or higher. The listed expense percentage is the portion of a fund's total assets the management company will charge to run the fund for a full year.
An investor is not charged directly for the expenses of a fund. The fund management company pulls the fund expenses from the assets of the fund. The result is a lower share price or dividend rate than if the fund did not have an expense ratio. Consider a hypothetical bond mutual fund. The fund portfolio earns total interest at a rate of 7 percent per year. The fund has a total expense ratio of 1 percent. The dividend yield to investors will net out to 6 percent as the fund management takes the funds expenses from the income earned by the fund's portfolio.
Although the expense ratio is not a direct charge to investors, the level of the ratio will affect the return to investors over time. Consider two Standard & Poor's 500 Index funds. If one fund has an expense ratio of 0.25 percent and the other 1.25 percent, the fund with the higher expenses will under-perform the the other fund by 1 percent every year. Assuming an average growth rate of 10 percent for the S&P 500, after 15 years the low expense fund will have increased in value by just over 400 percent. The high expense fund will grow by 350 percent -- a significant difference.