Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 17)

Mutual Funds (part B)

by

Charles Lamson

Expense Ratio

The expense ratio is simply how much money (what percentage) the mutual fund company takes off for itself to cover operating, administrative, and other expenses. This is the cost of owning the fund.

There is not much math involved here. All of the numbers that go into this figure are readily available through a variety of sources, but primarily the prospectus.

Once you have the numbers, you add them up and that gives you the expense ratio. This number is mandatory if you are going to consider different funds. If two funds have similar performance and tax consequences, then obviously the one with the lower expenses is the winner.

We can minimize tax consequences by picking the right category of fund or housing it in a tax-deferred account, like an IRA. We do not have any control over performance.

Expense ratios on the other hand, represent the amount of our money that is not invested. The lower the expense ratio, the more money is actually invested. You do not have to be a genius to see that picking a fund with a low expense ratio makes a lot of sense.

Components of the Expense Ratio

If you understand what goes into the expense ratio, it will help you make better investment decisions.

JUST A MINUTE Most fund managers are compensated based on their fund's performance.

Administrative Expenses

These are the keep the doors open kind of expenses, including rent, technology, mailings, printing, and support staff (like customer service and representatives that take phone orders). A well-run fund will have administrative expenses around 0.3 percent and lower. This does not sound like much, but if the fund has $500 million in assets, 0.3 percent is not chump change (that is $1.5 million).

Management Fee

The management fee may also be called the investment advisory fee and is used to pay the fund's manager. A fund manager is responsible for making sure the fund meets its investment objectives and makes lots of money. These folks are followed by some investors the way horseracing fans follow jockeys.

These fees usually run 1 percent or less (again that would be $5,000,000 if a fund had $500 million in assets). This is a lot of money and fund managers are under intense pressure to make sure the fund performs well. Actively managed funds (we will discuss them next) tend to pay their managers the most, mainly because the success or failure of the fund is more directly tied to them; index funds, on the other hand, would pay less because the investment decisions are fewer.

PROCEED WITH CAUTION Read the prospectus carefully for transaction fees or other fees. One fee that is fairly common is a low-balance fee, meaning if your account falls below a certain balance, you may be charged a fee.

For example, if you want to redeem (sell) $1,000 from your account and have the money wired to your bank, the fund company may charge a transaction fee for that service. Read the fine print carefully and you will avoid funds with high fees for services you frequently use.

Typical Expense Ratio

Now that you know what goes into the expense ratio, let us look at what a typical expense ratio is for different funds.

For actively managed funds, expect an expense ratio in the 1.5 percent range, while true index funds will sport an expense ratio in the neighborhood of .25 percent. As we look at different types of funds, I'll give you some guidelines about where the expense ratio should be.

The other thing to remember about expense ratios is they are paid to the mutual fund company regardless of the fund's performance or any other factor. That is why it is so important to consider the expense ratio in evaluating a mutual fund.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 130-133*

END

JUST A MINUTE

Most fund managers are compensated based on their fund's performance.

PROCEED WITH CAUTION

Read the prospectus carefully for transaction fees or other fees. One fee that is fairly common is a low-balance fee, meaning if your account falls below a certain balance, you may be charged a fee.