Investing comes with costs. In particular, mutual funds and exchange-traded funds charge a variety of different costs, and many of them get wrapped into a figure known as the total expense ratio in prospectus materials and regular fund reports. However, investors shouldn't expect to see expenses charged against their fund balances directly on their statements. Instead, it's important to understand how those expenses get paid and what impact they have on your total return.
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What the total expense ratio covers
The listed figure for total expense ratios in ETFs and mutual funds includes a number of different types of costs. Much of the expense ratio often goes to the fund manager, which is charged with responsibility for managing the fund's portfolio of investments. Other charges include spending on recordkeeping, custodial services to hold fund assets, legal expenses, and accounting and audit costs.
Some mutual funds include marketing expenses in their total expense ratio. These fees are often listed as 12b-1 fees, which refers to the SEC rule that authorizes fund companies to charge them.
Note, however, that some fund costs are not included in the total expense ratio. First, any sales charges that a fund imposes when you purchase or sell shares are not treated as costs for calculating the total expense ratio. In addition, the costs that the fund incurs to buy and sell investments aren't included in the ratio.
How the total expense ratio gets paid
Mutual funds don't present their shareholders with a bill for expenses. Instead, they typically take an amount equal to the total expense ratio directly from the income that the fund's assets generate. This has the net effect of reducing the amount of income available to shareholders.
In some cases, funds don't hold income-producing assets. For such funds, expenses are paid directly from cash held by the fund. A fund can sell assets in order to generate the cash necessary to pay expenses. This will reduce the net asset value of the fund by the amount of the expenses taken.
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Calculating your share of total expenses
Even though the amount of your expenses isn't explicitly listed on your statement, you can calculate it relatively easily. Take the total expense ratio and multiply it by the average balance you have invested in the fund over a 12-month period. The result will be the amount of fees you've indirectly paid.
Funds incur costs, and you'll end up paying for them. Looking at the total expense ratio is the best way to help you determine exactly how much you're losing to fees and other costs in a fund.
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