One of the most important characteristics about a mutual fund is its expense ratio. The expense ratio is the cost of running the fund and is charged to cover the expenses of running that fund, usually represented by a percentage of assets. Some of the things the expense ratio covers include, but are not limited to, the investment advisory fee, administrative costs, 12b-1 distribution fees, operating expenses, and paying for the fund manager’s Mercedes-Benz car allowance (just kidding on the last one).
The expense ratio is also one of the easiest things for you to control when you select a fund. You can’t predict the future with respect to returns, but you sure can predict how much of your investment is consumed by the operational expenses of a fund.
So, what are the three strata of mutual fund expense ratios? Passively managed funds, actively managed funds, and hedge funds (though hedge funds really don’t count, I had to throw them in there).
Passively Managed Funds
Passive funds are index funds, funds that don’t have a manager and management board actively making decisions on what investments to pursue. They don’t spend time researching companies or interviewing CEOs, they simply track an index such as the S&P 500 as closely as they can. Vanguard’s S&P 500 fund, the Vanguard 500 Index (VFINX), has an expense ratio of 0.18%. Fidelity’s S&P 500 fund, the Fidelity Spartan 500 Index, has an expense ratio of 0.10%.
Actively Managed Funds
Active funds are those mutual funds that have a manager and management team leading the way on deciding which investments to pursue. These funds generally have higher expense ratios, starting in the 1-1.5% range, simply because you need to pay people to conduct the research, make the decisions, and because you need to pay for the trading activity of the fund as well. If you take a look at some of the funds on Money’s Best Mutual Fund List of 2008, you’ll see them run the gamut. The Matrix Advisors Value fund costs 1.11%, Vanguard Windsor II costs only 0.33%, the T. Rowe Price Blue Chip Growth costs 0.81%, and the T. Rowe Price Emerging Markets Stock costs a pricier 1.21%. As you can see, the larger cap funds often charger lower expense ratios because there is less trading involved while the smaller cap and emerging markets funds have slightly higher ratios. Either way, they’re still far higher than the extremely low passively managed funds.
Hedge funds are a totally different animal, often charging high fees on both the asset amount and the profits earned. I wanted to throw these funds in there only because they represent the most expensive of the funds you’ll see and their name, hedge funds, don’t really indicate what they do anymore. Hedge funds are now essentially funds for the extremely wealth, thus they have less oversight by the SEC, and their fees are structured in a way that rewards performance. Hedge funds often will have an “expense ratio,” as a percentage of the managed assets, plus a fee based on the profitability of the fund. Something like 2% of assets and then 20% of profits is not unheard of.
There you have it, the three strata of expense ratios in the mutual fund world. It’s important to know where each of those lies so you don’t end up purchasing an actively managed fund that charges you an arm and a leg. When selecting funds, it’s valuable to check out resources like Morningstar to get a good idea of the landscape before selecting an investment.