Management fees and expense ratios are the cost of doing business if you buy mutual funds or exchange-traded funds. These expenses come with every type of fund available and eat away at investor returns. Generally speaking, the lower a fund's expenses over time, the greater return it can provide to shareholders, all other things being equal. However, management fees and expense ratios are legitimate costs associated with the operation of a fund.
While the management fee represents the costs that shareholders pay in order to reap the benefits of professional fund management, the expense ratio encompasses not only the management fee but also all of the other expenses related to operating a fund.
Understanding Management Fees
A mutual fund is a collective pool of money that professional managers invest in various securities on behalf of all shareholders. For these services, managers are paid, and their paycheck comes out of fund profits in the form of the management fee. Typically, the management fee that a fund charges is more than simply the salary it pays out to the managers. Certain administrative or other fees also find their way into the management fee percentage that appears on official fund documents.
Using the Expense Ratio
A mutual fund's expense ratio includes all of the costs necessary to run the fund, including profits for the fund company. A fund's management fee is simply a portion of a fund's overall expense ratio. Distribution fees, which are used to pay for the sales and marketing of a fund, including broker commissions, also are part of a fund's expense ratio. Shareholder service fees cover the cost of customer service and the provision of official mutual fund documents, such as statements, to shareholders. Other expenses, ranging from custodial expenses to legal, transfer and administrative expenses, all find their way into a fund's total expense ratio.
Average Fees and Expenses
According to Investopedia, average management fees for a mutual fund range between 0.5 percent and 2 percent of a fund's assets, although the average actively managed equity fund charges between 1.3 percent and 1.5 percent. These fees are paid regardless of how a fund performs. The U.S. Securities and Exchange Commission states that higher-expense funds do not, on average, perform better than lower-expense funds. Typically, passively managed funds, such as index funds, charge lower fees than actively managed funds.
Sales Loads and Other Costs
Many mutual funds are no-load, meaning they don't charge any sales commission when investors buy or sell shares. However, many funds still carry sales loads, particularly when it comes to buying shares. These sales commissions are not a part of the management fee or expense ratio of a fund, but rather are an additional fee. This means that on top of paying the annual operating fees, you'll pay a sales commission to buy the shares.
According to Investopedia, there is little to no evidence that paying a sales load translates to higher performance. However, bear in mind that some "no-load" funds charge purchase or redemption fees that are not considered "sales loads" because they are not paid as commissions to a broker but rather are used to cover fund expenses.