The expense ratio is the percentage of fund assets paid for operating expenses and management fees. It typically includes the following types of fees: accounting, administrator, advisor, auditor, board of directors, custodial, distribution (12b-1), legal, organizational, professional, registration, shareholder reporting, sub-advisor, and transfer agency. The expense ratio does not reflect the fund's brokerage costs or any investor sales charges. In contrast to the net expense ratio, the gross expense ratio does not reflect any fee waivers in effect during the time period.
Fund expenses (net of waivers and reimbursements) are subtracted from the fund's assets on a daily basis. This causes the expense ratio to be accrued evenly, with little daily effect to the fund's NAV. Most companies associated with the fund, such as the investment advisor, are actually paid on a monthly basis.
Morningstar lists four expense ratios:
Annual Report Gross Expense Ratio
Often referred to as the Audited Gross Expense Ratio, Morningstar pulls the annual gross expense ratio from the fund's audited annual report. Annual-report expense ratios reflect the actual fees charged during a particular fiscal year, while prospectus expense ratios reflect material changes to the expense structure for the current period.
Annual Report Net Expense Ratio
Often referred to as the Audited Expense Ratio, Morningstar pulls the annual net expense ratio from the fund's audited annual report. Annual-report expense ratios reflect the actual fees charged during a particular fiscal year, while prospectus expense ratios reflect material changes to the expense structure for the current period.
Note: The annual report expense ratio for a fund of funds is the wrap or sponsor fee only.
Prospectus Gross Expense Ratio
Also known as the Total Annual Fund Operating Expense Ratio, Morningstar pulls the prospectus gross expense ratio from the fund's most recent prospectus. Prospectus expense ratios reflect material changes to the expense structure for the current period, while annual-report expense ratios reflect the actual fees charged during a particular fiscal year.
Prospectus Net Expense Ratio
Also known as the Total Annual Fund Operating Expense Ratio Net of Reimbursements, Morningstar pulls the prospectus gross expense ratio from the fund's most recent prospectus. Prospectus expense ratios reflect material changes to the expense structure for the current period, while annual-report expense ratios reflect the actual fees charged during a particular fiscal year.
Note: The prospectus expense ratio for a fund of funds is the aggregate expense ratio as defined as the sum of the wrap or sponsor fees plus the estimated weighted average of the underlying fund fees.
Benefits
The expense ratio is useful because it shows the actual amount that a fund takes out of its assets each year to cover its expenses. Investors should note not only the current expense-ratio figure, but also the trend in these expenses; it could prove useful to know whether a fund is becoming cheaper or more costly. When considering high expenses vs. low expenses, potential investors must also consider the fund's category and its size. The funds in certain categories, such as the foreign-stock categories, have higher costs and therefore, higher expense ratios. As for size, smaller funds are normally costlier than larger funds, as they do not have the benefits of economies of scale.
Origin
Morningstar does not calculate expense ratios. Sources for expense ratios include the Annual Report - an audited trailing perspective - and the Prospectus - an unaudited projection.
Expense Ratios and Bond Funds
It’s critical to look for bond funds with low expenses. Expenses eat into total returns, and typically, only a narrow difference separates the returns of the leaders and laggards of a bond category. Also, high-cost bond funds tend to be riskier than low-cost funds. Expenses are deducted from a fund’s income payments. To keep yields at high-cost funds competitive, managers often make riskier investments, such as buying longer-duration paper, lower-quality debt, or complex derivatives. Managers with lower expense hurdles can offer the same returns without taking on the extra risk. How much is too much to pay? Many government or corporate high-quality-bond funds have expense ratios of 0.75% and less. For specialty-bond funds, such as high yield or world bonds, don’t pay much more than 1%.