What it is:
The expense ratio is the recurring management fees for a mutual fund. A fund company charges its fund holders the expense ratio each year (expressed in terms of a percentage of the fund's assets). The mutual fund firm uses these fees to pay for managerial expenses, administrative costs, 12b-1 fees and other various operational expenses.
How it works (Example):
The average expense ratio for an actively managed mutual fund is about 1.5%. This means that the mutual fund charges its fund holders an annual fee of 1.5% of the fund's total assets.
Generally, expense ratios are calculated to include:
1) Management fees -- Also called investment advisory fees, these generally range from 0.50% to 1.00% of the fund's assets.
2) Administrative costs -- These usually range between 0.20% and 0.40% of a fund's assets.
3) 12b-1 fees -- These cover the costs of fund marketing, advertising, and distribution and typically range from 0.25% to 1.00% of a fund's assets.
Why it Matters:
All mutual funds charge expenses to their fund holders and those that are actively managed or specialize in specific sectors generally have the highest fees. By contrast, index funds typically carry the lowest expense ratios. After all, since their goal is to duplicate the results of an underlying index, these funds' managerial fees tend to be very minimal. Ideally, higher fees would coincide with those funds that deliver the greatest returns. In reality, however, some of the market's worst performing funds also charge extremely high fees.
In general, history has shown that most mutual funds underperform the broader market, and they usually do so by roughly the same amount as their annual expense ratio. In other words, most funds perform in line with the market, but their total returns end up falling short due to stiff managerial, administrative and other fees.
The current expense ratios charged by most mutual funds are readily available from a variety of different sources. These include newspapers like the New York Times, as well as financial websites like Yahoo! Finance and Morningstar.