 Personal Finance PowerPoint Presentation, Expense Ratio. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia Expense Ratio, which you can find online. Take a look at the references, resources, continue your research from there. This by Adam Hayes, updated July 1st, 2021. In prior presentations, we've been taking a look at investment goals, strategies, tools, keeping in mind the two major categories of investments, that being the fixed income, typically the bonds, the equities, typically the common stock, also keeping in mind other tools we might be using, such as mutual funds and ETFs, possibly helping us to diversify even with less of an overall investment as opposed to investing in individual stocks, individual bonds. Keeping that in mind, we're asking what is an expense ratio, otherwise known as an ER here. So an expense ratio, ER, also sometimes known as the management expense ratio, MER, measures how much of a fund's assets are used for administrative and other operating expenses. So clearly, just like with a company here, we want them to be lean and mean on the investor's side of things. Remember, when you're investing, say, in the stocks of a company, you're investing in an ownership interest in the company. You would like the company to be generating revenue and reducing lowering the expenses. That includes the management expenses. So they have more money they can either give you in the form of a dividend or put back into the company in order to generate more revenue in the future and increase the stock price for us. When we're looking at managed funds, like mutual funds, for example, then we would like to have a similar kind of thing happening here. We're going to have to pay someone to manage the fund to be put in the funds in place. But we would like to be getting most of the money, having that management component lean and mean, so that most of that money goes to us here when we get returns on the investment. So an expense ratio is determined by dividing a fund's operating expenses by the average dollar value of its assets under management, otherwise known as the AUM. Operating expenses reduce the fund's assets, thereby reducing the return to investors. So the formula looks something like that. The formula for expense ratios is the total fund costs over the total fund assets. So what the expense ratio can tell you, operating expenses vary according to the fund or stock. However, the expenses within the funds remain relatively stable. So clearly, we would like to look at the expenses in a way that would be comparable to other funds. So if we're looking at different funds that have different amounts of money under management, that could be a little bit tricky. That's why we use ratios. Remember that ratios are helpful for us to judge performance like we do in sports, for example, which is just a form of job performance, same kind of thing here. The ratio can help us do comparisons to different funds and see the relative ratio for them, which could help us in decision making. For example, a fund with low expenses will generally continue to have low expenses. The largest component of operating expenses is the fee paid to a fund's investment manager or advisor. Other costs include record keeping, custodial services, taxes, legal expenses, and accounting and auditing fees. Or at least they got to pay the accountants, right? They should be paying. So any case, expenses that are charged by the fund are reflected in the fund's daily net asset value. That's the NAV. We talked about in prior presentations with the mutual fund typically done at the end of the day. So it's going to value the assets in the portfolio and do not appear as a distinct charge to shareholders. Expense ratios can be modified in several ways. The expense ratio is most often considered with the total expenses, but sometimes people want to understand gross expenses versus net. Components of an expense ratio. Most expenses within a fund are variable. However, the variable expenses are fixed within the fund. For example, a fee consuming 0.5% of the fund's assets will always consume 0.5% of the assets regardless of how it varies. So in addition to the management fees associated with a fund, some funds have an advertising and promotion expense referred to as a 12B1 fee, which we talked about in prior presentations, which is included in operating expenses. Notably, 12B1 fees within a fund cannot exceed 1% 0.75% allocated to distribution and 0.25% allocated to shareholders' servicing according to the FINRA rules. A fund's trading activity, the buying and selling of portfolio securities, is not included in the calculation of the expense ratio. Costs not included in operating expenses are loads, contingent deferred sales charges, those are the CDSCs we talked about in prior presentation, and redemption fees, which, if applicable, are paid directly by fund investors. So index funds versus actively managed funds. So now we're getting into the different kinds of funds. Again, it's really important to have an understanding of them. We'll drill down on some of these individual funds in a bit more detail in future presentations. The expense ratio of an index funds and an actively management fund often differ significantly. So remember, when you're thinking about, you would expect, like if you're thinking about these kind of expenses for the management of the fund, that if you had more leeway to the management, you're paying them to try to beat the market, then the expenses would be higher because you're thinking that they're going to try to beat the market. When we say beat the market, we're usually meaning what they're going to beat like the average of the market. The way we know the average of the market is the use of indexes. And so the index is kind of like an average of certain sectors of the market, like an S&P 500, for example. And so if you invest in like an index mutual fund, then they're going to tie to the index. They have a lot less liberty for their management, their hands are tied. You still have to pay for them managing the fund, but you would expect then the fees to be a lot lower in that instance than you're betting on the market in general. So index funds, which are passively managed funds, typically carry very low expense ratios. The managers of these funds are generally replicating a given index. The associated management fees are thus lower due to the lack of active management as with the funds they mirror. So actively managed funds employ teams of research analysts examining companies as potential investments. Those additional costs are passed on to shareholders in the form of higher expense ratios. So we talked a little bit in the past in terms of is it worthwhile to be paying these, these are pretty highly paid professionals, you would think, because they're trying to beat the market with these different kind of tools. So you'd have to clear their expenses of them doing that in order to make it worthwhile as opposed to betting on just the average or the market going up over time in the long run. So you might have different ideas depending on your ideas about how efficient the market is and how good and how valuable paying a manager would be to actively manage. Remember that when you watch shows like stock shows like a Bloomberg or something and they interview somebody, they're usually interviewing people that are active managers. So they're going to be biased, you would expect, towards active management because that's what they do. So, you know, you have to kind of keep that in mind whenever you're talking about investments, right? Who are you talking to? What's their interest? Do they have an interest in their personal career as to why they might be taking a particular position and do they have an interest in terms of you doing business with them as to why they might be taking a personal kind of perspective. But in any case, the Vanguard S&P 500 ETF and index fund that replicates the standard and pours S&P 500 index has one of the lowest expense ratios in the industry at .03 annually, .03% annually. That's what I'm talking about. I like it. So at this level, investors charged just $3 per year for every $10,000 invested. The Fidelity Contra fund is one of the largest actively managed funds in the marketplace with an average expense ratio of .86% or $86 per $10,000. So examples of expense ratios in general, passively managed funds such as index funds will typically have lower expense ratios than actively managed funds. Below are two examples of one of each. So you got the AB large cap growth fund. The AB large cap growth fund is an actively managed fund. So that's the more expensive one with a net expense ratio of .61%. The fund currently has a fee waiver and expense reimbursement of .01%. Management fees for the fund are .5%. The fund invests primarily in large cap US stocks with high growth potential. It typically includes 50 to 70 holdings. So the actual investments, different companies, nothing in essence. So the T-Raw Price Equity Index 500 fund, the T-Raw Price Equity Index 500 fund is a passive fund. The cheaper one typically is 6 to replace the S&P 500. So it's going to be tied to an index, an average of the market, trying to take a sample of the market in other words. And then we're just trying to tie to that sample. So it should be fairly easy to do or comparatively easy to do by investing the majority of its assets into all of the stocks in the S&P 500. Its gross and net expense ratio is .19%. It has a management fee of .06%. So the difference between the expense ratios and management fees. So we have the mutual funds charge management fees to cover their operating costs such as the cost of hiring and retaining investment advisors whose managed funds, investment portfolios and any other management fees payable not included in the other expenses category. Management fees are commonly referred to as maintenance fees. A mutual fund incurs many operating fees associated with a running fund other than the costs to buy and sell securities and paying the investment team to make the buy-sell decision. These other operating fees include marketing, legal, auditing, customer service, office supplies, filing costs and other administrative costs. While these fees are not directly involved with the making the investment decisions, they are required to ensure the mutual fund is run correctly and within the Securities and Exchange Commission Federal Body Oversight Body Regulatory Body SEC requirements. The management fee encompasses all direct expenses incurred in managing the investment such as hiring the portfolio manager and investment team. The cost of hiring managers is the largest component of management fees. It can range between 0.5% and 1% of the fund assets under management or AUM. Even though this percentage seems small, the absolute amount is in millions of U.S. dollars for a mutual fund with $1 billion of AUM asset under management. Depending on the reputation of management, highly skilled investment advisors can command fees that push a fund's overall expenses ratio quite high. Notably, again, you would expect that actively managed individuals are going to be fairly highly paid individuals. You would think they would need to be if they're going to actually be able to outpace the market to a degree that they're going to be able to pay for the added fees of them doing so. Notably, the cost of buying or selling any security for the fund is not included in the management fee. Rather, these are transaction costs and are expressed as the trading expense ratio in the prospectus. Together, the operating fees and management fees make up the expense ratio. So what does expense ratio mean? The expense ratio refers to how much a fund's assets are used toward administrative or other operating expenses because an expense ratio reduces a fund's assets, it reduces the returns investors receive. What? I don't like my returns being reduced. What is an example of an expense ratio? An example of an expense ratio would be the 0.21% that the T-Raw Price Equity Index 500 fund charges. It means that 0.21% of its assets are used toward paying administrative and operating costs, reducing an investor's returns by that amount. Why is expense ratio important? An expense ratio is important because it lets an investor know how much they are paying in costs by investing in a specific fund and how much their returns will be reduced by the lower the expense ratio, the better because it means that an investor is receiving higher returns on their investment capital. How is expense ratio calculated? The expense ratio is calculated by dividing total fund costs by total fund assets. What is a good expense ratio for a mutual fund? Mutual funds that invest in large companies should not have an expense ratio above 1%, while funds that invest in smaller companies should not have an expense ratio above 1.25%. So you would think the larger companies would be more established and whatnot, more risk maybe with the smaller funds and therefore possibly needing more active management, maybe depending on the fund that you are taking to deal with that world of fund type. So there are funds with expense ratios higher than this and they can either be viewed as expensive funds or funds that provide a special service justifying their high costs.