Expense Ratio

Total Annual Fund Operating Expenses ("Expense Ratio") — the line of the fee table in the prospectus that represents the total of all of a fund's annual fund operating expenses, expressed as a percentage of the fund's average net assets. Looking at the expense ratio can help you make comparisons among funds. [http://www.sec.gov/investor/pubs/inwsmf.htm#factors Sources of Information]

The expense ratio of a stock or asset fund is the total percentage of fund assets used for administrative, management, advertising (12b-1), and all other expenses. An expense ratio of 1% per annum means that each year 1% of the fund's total assets will be used to cover expenses. The expense ratio does not include sales loads or brokerage commissions.

Expense ratios are important to consider when choosing a fund, as they can significantly affect returns. Factors influencing the expense ratio include the size of the fund (small funds often have higher ratios as they spread expenses among a smaller number of investors), sales charges, and the management style of the fund. A typical annual expense ratio for a U.S. domestic stock fund is about 1%, although some passively managed funds (such as index funds) have significantly lower ratios: for example, the Vanguard US Large Cap ETF has an expense ratio of 0.07%. [http://www.ishares.net/content/stream.jsp?url=/publish/repository/documents/en/downloads/product_list_uk.pdf]

One notable component of the expense ratio of U.S. funds is the "12b-1 fee", which represents expenses used for advertising and promotion of the fund. 12b-1 fees are generally limited to a maximum of 1.00% per year (.75% distribution and .25% shareholder servicing) under NASD Rules.

Waivers, Reimbursements & Recoupments

Some funds will execute "waiver or reimbursement agreements" with the fund's adviser or other service providers, especially when a fund is new and expenses tend to be higher (due to a small asset base). These agreements generally reduce expenses to some pre-determined level or by some pre-determined amount. Sometimes these waiver/reimbursement amounts must be repaid by the fund during a period that generally cannot exceed 3 years from the year in which the original expense was incurred. If a recoupment plan is in effect, the effect may be to require future shareholders to absorb expenses of the fund incurred during prior years.

Changes in Expense Ratio (Fixed & Variable Expenses)

Generally, unlike past performance, expenses are very predictive. Funds with high expenses ratios tend to continue to have high expenses ratios. An investor can examine a fund's "Financial Highlights" which is contained in both the periodic financial reports and the fund's prospectus, and determine a fund's expense ratio over the last five years (if the fund has five years of history). It is very hard for a fund to significantly lower its expense ratio once it has had a few years of operational history. This is because funds have both fixed and variable expenses, but most expenses are variable. Variable costs are fixed on a percentage basis. For example, assuming there are no breakpoints, a .75% management fee will always consume .75% of fund assets, regardless of any increase in assets under management. The total management fee will vary based on the assets under management, but it will always be .75% of assets. Fixed costs (such as rent or an audit fee) vary on a percentage basis because the lump sum rent/audit amount as a percentage will vary depending on the amount of assets a fund has acquired. Thus, most of a fund's expenses behave as a variable expense and thus, are a constant fixed percentage of fund assets. It is therefore, very hard for a fund to significantly reduce its expense ratio after it has some history. Thus, if an investor buys a fund with a high expense ratio that has some history, he/she should not expect any significant reduction.

Expenses Matter Relative to Investment Type

There are 3 broad investment categories for mutual funds (equity, bond, and money market - in declining order of historical returns). That is an over simplification but adequate to explain the effect of expenses. In an equity fund where the historical gross return might be 10%, a 1% expense ratio will consume approximately 10% of the investor's return. In a bond fund where the historical gross return might be 8%, a 1% expense ratio will consume approximately 12.5% of the investor's return. In a money market fund where the historical gross return might be 5%, a 1% expense ratio will consume approximately 20% of the investor's historical total return. Thus, an investor must consider a fund's expense ratio as it relates to the type of investments a fund will hold.

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