Mutual Fund Expenses Explained
by Gary Foreman, Stretcher.com

Is your mutual fund management company getting rich while you're not? You know that they make money by managing some of yours. But are they charging you too much? How can you tell? Let's answer some of the most common questions about mutual fund expenses.

What are operating expenses? They'll include the payroll for investment analysts, phone bills, rents for office space and the cost of printing and mailing your statements. Basically, it's the cost of managing your money. One notable exception is the commission that the fund pays to buy and sell securities. That's not included under operating expenses. It's considered a 'transaction expense' in most cases.

How do you calculate expense ratio for a specific fund? The math is pretty simple. Just take the operating expenses and divide them by the average assets. Both figures will be available in the prospectus or quarterly report. For instance, a fund with $10 million in assets and expenses of $100,000 would have an expense ratio of 1.0%.

How much is a 'reasonable' amount to pay for fund expenses? That depends on two things. First, how hard is it to manage the money and, secondly, how aggressive your managers are. Let's take two simple examples. First, consider a fund that buys US Treasury bonds and plans to hold them to maturity. There's not much research required so the expenses should be low. In 1996 the average expense for a government bond fund was 1.02%.

Compare that to managing a long-term growth stock fund. You'll want your analyst to do a good job in finding the next Microsoft. That takes time and effort. And the average cost of managing a growth fund was 1.42% in '96. As you would expect, the cost to manage international funds or find small emerging companies is even greater.

Can higher expenses 'buy' better managers? Sometimes. The most talented managers should make more. What you really want to know is if the extra expense is worth it. The best way to see if a fund really deserved a higher expense ratio is to see how they've performed in direct comparison to other funds and the market. If they've done a better job on a regular basis, the higher expenses shouldn't bother you. Conversely, if they haven't outperformed, find another fund.

How am I charged with the expenses? Is it on my quarterly statement? Unfortunately, you'll have to do a little bit of digging to find out how much of your money the fund spent. It's not found on your statement. You'll need to go to the fund's income statement in the quarterly report to find the answer. Most people toss the report without looking at it.

A number of industry 'watchdogs' are pushing to have fund expenses shown on your fund statement. They argue that if people knew how much they were spending on expenses there would be more pressure to control the cost. Fund managers counter that the increased cost of collecting and reporting that information would only increase the expenses.

How do expenses affect my earnings? They're subtracted before you see your earnings. If a fund earns 10% and the expenses are 1.2%, you'll see a return of 8.8% (10.0 minus 1.2 equals 8.8). That's not so bad when markets are going up, but remember that the expenses go on even if a fund is losing money. A half-percent difference in expenses can seem huge if your fund is only making a couple of percent.

Are 'big funds' less expensive than smaller ones? Yes, but not by as much as you'd think. Obviously, it doesn't cost twice as much to manage a fund that's twice as big. But you need to remember that the mutual fund companies want to make a profit, too. All of the savings of a big fund don't come back to you. Some of that savings goes to the fund company as additional profits.

What should I look for when I consider fund expenses? Look for two things. First, how does the fund's expense ratio compare to other similar funds? If it's higher, check to see if it's justified by performance. Don't forget to make sure that the manager that produced the past performance is still managing the fund.

Second, if the fund is part of a family, take a look at the average family expenses, especially if you're buying a load or 12b-1 fund. You may want to switch to a different fund within the family some day. That could be less attractive if the whole family has higher expense ratios than the average. And there's quite a bit of difference in average family expenses. Some have a ratio of less than 3/4 of a percent and many others are over 1.5%.

One final thought. You do need to keep all this in perspective. In some ways it's the same as deciding to order pizza. How much time and money would it take you to make the pizza? Is it a good value? Unless you're really into tracking and researching stocks, you may be getting a pretty good deal for your one percent or so. That doesn't mean that you shouldn't consider expenses in picking funds; just remember that it's only part of the equation.

Gary Foreman is a former purchasing manager who currently edits The Dollar Stretcher website www.stretcher.com!

Copyright 2004 by Gary Foreman. Reproduction without permission prohibited.