An expense ratio is a fee charged by an investment company to manage the shareholders’ funds. Investment companies such as mutual funds often incur various operating expenses when managing investors’ funds, and they charge a small percentage on the funds under management to cover the expenses.
Some of the expenses incurred by investment companies include advertising cost, management cost, administration cost, management fee, and legal cost. The expenses are deducted from the investor’s funds, and it reduces the overall returns attributable to investors.
Costs Included in the Expense Ratio
The number of operating expenses incurred when managing investors’ funds vary across different investment companies. A typical fund may incur the following expenses:
1. Management fee
The management fee is paid by an investor to the portfolio management company as compensation for managing funds on their behalf. The fee is intended to compensate the fund managers for their time and expertise in selecting high-return securities for their clients and in managing the portfolio of investments.
Management fees make up a large portion of the expense ratio and can range from 0.5% to 2.0%. Investors prefer portfolio management companies that charge a lower management fee since a higher fee reduces the return on their investments.
2. Legal expenses
Investment funds may also incur certain legal costs in the management of shareholder funds. Legal fees are paid to lawyers to process paperwork related to stock certificates, SEC filings, licenses, as well as compliance with various regulations. The fees may also be paid to lawyers representing the company when it is involved in legal disputes with regulators, competitors, investors, and other stakeholders. Unlike management fees, legal expenses make up a small percentage of the expense ratio.
3. Transfer agent fees
These fees are paid to transfer agents who may be a bank or trust company that is assigned the responsibility of maintaining investor records. When customers sell or buy part or all of their investments in the portfolio company, the client’s accounts need to be updated regularly to reflect such changes.
Transfer agents are tasked with handling such tasks in order to track the day to day changes in the account statements. They process purchase requests, issue certificates to new owners, handle cases of stolen or lost certificates, and act as intermediaries between the fund investors and the company.
5. Marketing fees
Marketing fees are costs incurred by the investment fund to advertise its products and services to potential shareholders for the purpose of raising more money for investment. Such fees are used to create advertising banners, print and distribute pamphlets to potential shareholders, as well as sponsor ads to the target market.
The more money an investment fund holds, the more portfolios that the company can invest in, and this means a higher management fee for the fund managers. Marketing fees are added to the expense ratio and make up a small percentage of the ratio.
Changes in the Expense Ratio
The expense ratio of a company is usually predictable, and an investment fund with a high expense ratio will likely continue operating with a high expense ratio. An investor planning to get their funds managed by a mutual fund can review a fund’s prospectus to find its average expense ratio over the last five years.
The operating expenses incurred by a fund are comprised of both fixed and variable expenses, which are calculated as a fixed percentage of the fund’s assets. This means that the expenses behave as variable expenses since the total expenses will depend on the total assets under management at any given time.
For example, assume that a fund charges a management fee of 1% of the total assets under management. It means that the fund will charge a constant 1% regardless of any increases in the total assets under management. If the fund total assets amounted to $30,000,000 in 2017, and then increased to $35,000,000 in 2018, the management fee charged will be equal to $300,000 and $350,000, respectively. Similarly, a fixed cost such as rent will vary in percentage depending on the total assets that are under management across different periods.
Index Funds vs. Actively Managed Funds
Index funds and actively-managed funds charge different expense ratios due to the difference in their modes of operation. Index funds are passively-managed funds, and this means that the fund manager is only tracking the portfolios with the fund’s benchmark index. Passively-managed funds do not require an active management team, which means that the expense ratio can be maintained on the lower side. Passive index funds charge an average expense ratio of 0.2% or lower.
On the other hand, actively managed funds employ analysts and research teams to identify and analyze potential investments that offer a higher return. Actively managed funds often incur high operating costs, and the costs are passed on to the shareholders in the form of expense ratios. The average ratio for actively managed funds ranges from 0.5% to 1.0%
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:
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