An expense ratio is the percentage of your investment in a mutual fund collected by the company to pay for the fund's operations, including salaries and trading costs. In general, the lower the expense ratio, the better, since higher ratios mean higher costs that chip away at an investor's profits. Different types of funds, though, have different expense ratios, and it's acceptable for an actively managed fund to have a ratio that's several multiples of a passively managed index fund.
Load vs. No-load Funds
Mutual funds are classified as either "load" funds or "no-load" funds. In a "load" fund, an investor is charged a certain percentage of his investment immediately upon buying shares of the mutual fund. Most investment advisers suggest avoiding these funds and investing in "no-load" funds instead. No-load means there is no payment or charge at the initial investment, although certain funds will charge a fee if an investment is sold within a set amount of time (90 days, 180 days and 1 year are the most common time frames).
A fund can be either actively or passively managed. In active funds, an experienced investment professional with a good track record selects a limited number of investments, usually in stocks or bonds, that she thinks will perform well and deliver large returns. The fund's holdings are likely to change more frequently to take advantage of investment values. A passive fund, such as an index fund, or one that focuses on government bonds, or on stocks of energy companies, simply seeks to mirror the performance of its market segment. Since the fund needs only to purchase the securities making up a representative sample of the chosen focus area, very little active management is required, and expense rations are thus lower.
Index funds attempt to exactly mirror the performance of a stock or bond index, such as the S&P 500 Index, an index of shares of the 500 largest publicly traded companies in the United States. An S&P 500 Index fund holds all 500 stocks in the nearly the exact ratios of their value in the index. Because index funds have simple trading goals, to mirror the performance of an index, they have low expense ratios. Many index funds have expense ratios below 0.2 percent.
More complex funds, such as those holding both stocks and bonds, tend to have higher expense ratios because they hold a wider variety of securities and need to complete more trading activities. Actively managed funds, which may seek to make larger numbers of trades to maximize gains and hold a wider variety of investments, may offer the potential for higher returns but will generally have higher expense ratios.
Though each investment company is required to prominently list the expense ratio of its funds on the fund website, it can be difficult for investors to compare the expense ratios of similar funds. One resource for accurate comparisons is provided by the investment advisory firm Morningstar, which rates funds from various companies and provides comparisons of expense ratios. A link to Morningstar's website is provided in the Resources section.
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