Published July 16, 2002

Getting the Most Bang for Your Buck:
The Mysterious Expense Ratio

As the old saying goes, there is no such thing as a free lunch. Similarly, there is no such thing as a mutual fund with free service. Everything has its price, and, in addition to owning a pro-rata share of the fund's investments, investors also must bear their share of the fund's operating expenses. In its most basic form, investors in a mutual fund are hiring an investment manager to invest their dollars. There is nothing wrong with compensating the fund for its managerial prowess and shareholder services. No matter the strength (or, for that matter, weakness) of a fund's performance, however, investors must pay attention to the fees their fund assesses to make sure they are not being overcharged.

Although a detailed record of a fund's expenses are divulged on a dollar basis in its annual and semiannual reports, the amount charged is usually disclosed as a percentage of its net assets, a number known as the expense ratio. The easiest way to think of an expense ratio is as the amount charged per $100 of assets. Take, for example, Fidelity Small Cap Stock Fund (reviewed in this issue on page 945). On an annualized basis, the fund charges an expense ratio of 1.12%. This means that for every $100 of the fund's net assets, each shareholder pays $1.12 toward the operational costs of the fund.

The expenses faced by a fund's administrator can be numerous, but the most explicit include costs that one would expect to find in any business, such as salaries and other general office expenses. For the most part, the expense ratio has two or three components, all of which are expressed as a percentage. It is important to note that expense-ratio components are annual charges, not one-time expenses such as sales loads and redemption fees that are in addition to the fund's annual expense ratio.

All fund expense ratios include a management fee, which is, essentially, the compensation paid to the investment advisor or manager for this service. It also usually includes the salaries of certain support staff, such as analysts. The amount usually hovers around 1.00% and is often adjustable—as the fund's assets grow, the percentage can shrink. The second component is the 12b-1 fee—which can be used to pay for the distribution, literature, and advertising costs of the fund. The third and final component is where funds have a bit of flexibility—administrative costs. Totaling the management fee and the 12b-1 fee rarely add up to the total expense ratio. The margin of difference is what fund families charge for the various services they provide to the shareholders of all their funds, including legal and accounting fees and customer-service operations.

Granted, without many of these services, funds could not function. There is a line, however, between incurring necessary costs and paying through the nose, and for many funds this determination may not be clear-cut.

To aid investors with this determination, the "Historical Array" on each fund review in The Value Line Mutual Fund Survey includes a line entitled "Expense Relative the Objective." This number compares the fund's expense ratio to the average ratio charged by other funds in the objective group. A number less than 1.0 indicates the fund's ratio is lower than average, while a number greater than 1.0 indicates a higher-than-average charge. Of course, if an investor feels he or she has been adequately rewarded for the expense incurred, seeing an above-average ratio may not be cause for alarm. On the other hand, if an investor is on the fence in trying to decide between two offerings, the relative expense ratio is a handy tool. Although the expense ratio and the comparative number should not be the "make-or-break" factor in one's decision, it should certainly play a part.

William Lewittes
Issue Chief