Q&A: Behind mutual funds' expense ratios

Q: Most of my investments are in mutual funds. A friend of mine told me that I should pay attention to a fund's expense ratio and seek funds with low expenses. What does this expense ratio include?

A: All mutual funds, including no-load funds, have expenses that are passed along to investors. These expenses typically average about 1.3 percent per year in stock mutual funds, but the range of actual expenses can vary dramatically. Some index funds have annual expenses as low as 0.09 percent; other funds may have annual expenses of 2 to 3 percent. The level of expenses can depend upon the fund's investment objective. Large cap funds have-or should have-the lowest expenses; small cap and international funds typically carry higher expenses. Management style can also have an impact on expenses: Index and passive-asset-class funds generally have lower expenses than actively managed funds.

The annual expense ratio usually includes the following types of fees: accounting, administrator, adviser, auditor, board of directors, custodial, distribution, legal, organizational, professional, registration, shareholder reporting, sub-adviser, and transfer agency. The expense ratio does not reflect the fund's brokerage costs or any investor sales charges. This point is important because the fund's brokerage costs can be significant. In addition to noting a fund's expense ratio, you should determine a fund's turnover rate. This figure is disclosed in the fund's prospectus and on various investment websites. A turnover rate represents the percentage of a fund's holdings that have changed during the past year. For example, a turnover ratio of 50 percent means the fund holds a stock in its portfolio for about two years on average. A higher turnover ratio translates into higher expenses to the investor. A fund with a 50 percent turnover ratio is probably passing on an additional 0.5 percent of expenses to investors. This fee is in addition to those included in the annual expense ratio.

Send your money management questions to memoney@advanstar.com (please include your regular postal address). Answers to our readers' questions were provided by Sherman L. Doll, CPA, Thomas, Wirig, Doll & Co., Walnut Creek, California.