A total expense ratio is a measure of the costs to manage and run a mutual fund, compared to the assets in the fund itself. The total expense ratio is calculated by dividing the fund’s total costs by its total assets. Comparing total expense ratios of two or more funds will indicate which fund is operating most efficiently. However, it is important to compare funds of similar sizes, since some costs are fixed regardless of the size of the fund. Funds with higher total expense ratios will provide lower returns to investors.
One of the items included in a fund’s total expense ratio, sometimes simply called the expense ratio, is the 12B-1 fee. The 12B-1 fee, whose name refers to the section in the Investment Company Act of 1940 that regulates such fees, represents the marketing or distribution costs incurred annually for the fund. Funds that do not charge a sales charge, or load, will have higher 12B-1 fees than those that do have a sales load, because costs are incurred to market the fund that would otherwise be covered by the sales charge. The 12B-1 fee is an annual cost that does not disappear over time, like some sales charges.
Other costs are included in a mutual fund’s total expense ratio, including the costs to manage the fund. These costs may include charges incurred by the fund when shares of stock within the fund are traded, as well as the salary of the portfolio manager. Funds that use active management, with a fund manager or team of managers who evaluate each potential transaction, will have higher costs than those that use passive management, in which the portfolio mirrors an index and only trades when the index adds or removes stocks.
When assessing the attractiveness of a mutual fund by comparing its total expense ratio with that of one or more other funds, it is important to compare ‘apples to apples.’ Besides ensuring that the funds are of comparable sizes in terms of total assets, there are other factors to consider. For example, weighing a tax-efficient fund against one that does not consider the tax impact when selecting stocks does not provide a valid comparison. The tax-efficient fund may have higher expenses, but may still be a better investment depending on the investor’s tax situation. Be sure to compare the same share class as well, as that can impact the amount of the 12B-1 fee and other costs.