Reader Question: Expense Ratios

A reader wrote to me a few days ago with the following question:

"Hi Shadox,

I've recently come across your blog and I'd like to say that I enjoy it very much. I do not work in the finance / accounting field so I am not very knowledgeable when it comes to personal finance. I am trying to correct this by trying to read as much as I can about it and usually I rely on the "... for Dummies" kind of books.

Anyway I'd like to ask you about a topic which still seems very confusing to me.

It's about expense ratios.

I read one of John Bogle's [founder of Vanguard - shadox] books on investing and I am totally sold on investing in low expense ratio index funds. So low expense ratios are good - that I know. But what exactly is an expense ratio? Is a 12b-1 fee included in an expense ratio?

You give an example in one of your posts: "let's say that your equity fund generates an average return of 8% a year. If your fund charges an expense ratio of 2%, you are essentially paying a commission of 25% on your profit!

The question I have is, what happens if your fund's yearly average return is negative: does money still come out of your fund to pay the expense ratio? If yes, how much? Thank you very much for your help."

I have responded to Florin's question in a private e-mail, but I think that this is an excellent question that is probably of interest to other readers, so here is a more detailed version of the answer I sent him:

First of all, most of us aren't investment advisers and don't work in the financial sector. Since personal finance is not typically taught in school most of us are left to fend for our selves and come up with our own ways of getting the information we need. Your strategy of educating yourself by reading books is certainly an excellent way to go. I do the same.

So, what are expense ratios anyway? The SEC defines expense ratios as follows:

"Expense Ratio — the fund's total annual operating expenses (including management fees, distribution (12b-1) fees, and other expenses) expressed as a percentage of average net assets."

OK... so what are 12b-1 fees? From the same source:

"12b-1 Fees — fees paid by the fund out of fund assets to cover the costs of marketing and selling fund shares and sometimes to cover the costs of providing shareholder services. "Distribution fees" include fees to compensate brokers and others who sell fund shares and to pay for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. "Shareholder Service Fees" are fees paid to persons to respond to investor inquiries and provide investors with information about their investments."

So to put all this in plain English, a fund's expense ratio includes all expenses paid by an investor to the mutual fund including any associated marketing expenses (but you may still be paying other fees to your broker or financial firm - for example, for buying and selling your fund shares).

To Florin's specific question, the expense ratio is paid as a percentage of assets, and you pay it regardless of whether your fund makes money or loses money in any given period. As an example, if you have $1000 invested in a fund with a 1% expense ration and the fund returns 10% in that year, your holdings are now worth $1100 and the fee you will pay that year will be $11. If the fund lost 10% that year, your fees would be 1% of the remaining $900, or $9. Make money or lose money, you still need to pay your fund's expense ratio. 

Unfortunately, the only entity who is guaranteed a return on your investment is your mutual fund company... :-)

Still, that's not a reason not to invest. It is a reason to minimize your costs.

I love answering reader questions, so if you have any, please send them to me via e-mail (you can find my address on the left column of this page) or simply leave a comment with your question on one of my posts.