There are many ratios used in the financial industry to represent certain basic activities. The Expense Ratio (ER) is a common figure used by mutual funds to express the overhead costs of management. Here is more information on what is included in the expense ratio and why it is important.
Expense Ratio is Mutual Fund Operating Costs
Quite simply, the expense ratio (or management expense ratio) is a measure of the costs incurred by the administration while operating a mutual fund. This might be called overhead in the parlance of other businesses. The ER is usually quoted as an annual percentage.
The mutual fund’s total “operating expenses are divided by the average dollar value of its assets under management” according to the Investopedia.com website. The mutual fund must pay off these operating expenses subtracting them from the net asset value (NAV). This reduces the dividend amount paid to investors. A 1.00% expense ratio means that 1.00% of all the fund’s assets go to cover these management expenses.
What is Included in the Expense Ratio?
Common elements of the Management Expense Ratio include the adviser’s fee, paperwork, record-keeping, legal compliance, accounting, auditing and taxes. Investopedia discusses a “marketing cost” (12b-1 fee) that might also be included in this measurement. In fact, the Financial Industry Regulatory Authority (FIRA) has set a maximum of 1.00% per year for this 12b-1 fee according to Wikipedia.
Why is the Expense Ratio Important?
Investors can find the expense ratio in the “Financial Highlights” of the mutual fund’s reports. This can be an important mutual fund comparison tool.
The successful investor maximizes his per unit return on investment (ROI). Thus, if he is comparing two mutual funds, he would use the expense ratio to determine the efficiency of the management in accomplishing their goals. The financial industry has certain standards for acceptable expense ratios and high ratios can be a red flag.