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The Short Answer

Fund Expense Ratios: What Are You Paying For?

We shed some light on the costs fundholders pay.

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Running a mutual fund, like running any business, has certain costs associated with it, and every party that performs a function along the line needs to get paid somehow. But as Morningstar's John Rekenthaler and Paul Ellenbogen recently pointed out, fund prospectuses often paint those expenses in very broad strokes, and reporting methods vary; for instance, many funds don't report these fees under clear labels such as "administrative fees" or "operational fees" or "distribution fees." Thus, it's not always easy to understand what the underlying components of the overall expense ratio are.

Let's slice up the expense ratio and look at some of the items that fundholders pay for.

First, What Is an Expense Ratio?
A fund's expense ratio expresses the percentage of fund assets deducted each fiscal year for fund costs, which include management fees, administrative fees, operating costs, and sometimes even marketing and distribution costs incurred by the fund. (Portfolio transaction fees, or brokerage costs, as well as initial or deferred sales charges are not included in the expense ratio.) 

If the fund's asset base is small, its expense ratio can be high because the fund must pay these various costs from this smaller asset base. Conversely, as the net assets of the fund grow, the expense ratio should ideally decrease as costs are spread across the wider base. Price is one of the components, or "pillars," of our forward-looking Morningstar Analyst Rating (funds' "medalist" ratings). Our analysts look for this trend of inverse correlation of fund asset growth to fund expenses as a sign that funds are passing along economies of scale to investors. (One thing to note, however, is that this relationship is not 100% black and white; some of the fund's costs would actually grow with assets--for example, a larger fund would need to send out more reports and need more shareholder servicing reps. But other costs, such as management fees, should generally scale down because management doesn't need twice the personnel to manage twice the asset base.)

Fund boards are tasked with overseeing the operations of a mutual fund on behalf of its shareholders. It's the board members' responsibility, then, to pay attention to how much of overall expenses are devoted to these different slices of an expense ratio and vetting these various costs, whether paid to external or in-house vendors, against what other service providers would charge for similar services. Board oversight is another element of our Morningstar Analyst Rating, which is encompassed under a fund's Parent score.

Management Fee
This is the part of the fund's expense ratio that goes to paying the manager to run the fund. This cost pays not just the manager's salary, but the salaries of analysts and all of the other expenses associated with the management of the fund, such as travel and research tools. (This fee is often much lower with index funds or ETFs, but it's still there.) Sometimes, you'll see this listed as the investment advisory fee in the fund's annual report. Morningstar.com collects this information and breaks it out on the Expense tab of the fund quote page. For instance, the overall expense ratio of the Gold-rated  T. Rowe Price Mid-Cap Value (TRMCX) is 0.80%. Its management fee of 64 basis points makes up 80% of that total. 

Some funds' management fees have performance adjustments. For instance,         Fidelity Magellan (FMAGX) has a performance-fee adjustment, meaning that its expense ratio can fluctuate based on the fund's three-year return versus the S&P 500. (For every percentage point of out- or underperformance, the fee is adjusted by 0.02%, up to a maximum of 0.2%.) This type of performance-based fee can work to shareholders' advantage by not requiring them to pay as much when the fund has lagged, so Morningstar generally supports such fees as long as the swing is modest.

Custodian Fee
By law, a mutual fund company must store the securities and cash of the underlying mutual funds with a qualified custodian, usually a bank. This protects shareholders in the event that the mutual fund provider goes bankrupt.

The fees charged by the custodian for this service are a component of the expense ratio listed in the annual report. For instance, Gold-rated  Vanguard Wellington (VWELX) shareholders paid $830,000 in custodian fees for the year ended Nov. 30, 2014. Though that number sounds like a lot in isolation, it's a big fund (currently $84 billion in assets) and really only a very small slice of the fund's 0.26% annual expense ratio.

Transfer Agency Fees
Fund companies must also use a registered transfer agent, which can be an outside organization such as Boston Financial Data Services or  U.S. Bancorp (USB), or an entity that is affiliated with the mutual fund company (many larger fund companies, such as Vanguard, Fidelity, American Funds, and T. Rowe Price have wholly owned transfer agents). The transfer agent fulfills many roles for mutual fund shareholders, such as maintaining records of shareholder accounts; calculating and disbursing dividends and capital gains; and preparing and mailing shareholder account statements, federal income tax information, and other shareholder notices, according to the FDIC. Mutual fund transfer agents may also process transactions and prepare and mail statements confirming shareholder transactions and account balances. The transfer agent may also handle shareholders' customer service inquiries.

Given the number of open-end mutual fund shares that are bought and sold every day, keeping updated and accurate records of shareholder information is not only vital, it can be an enormous undertaking. And mutual fund shareholders all pay a fee for this service, whether the service provider is in-house or external. For instance, Bronze-rated  American Funds Growth Fund of America (AGTHX) shareholders paid nearly $154 million in transfer agent fees for the year ended Aug. 31, 2014. This fund, which currently has around $138 billion in assets, charges a 0.66% annual expense ratio, and the transfer agent fees are a slice of that.

12b-1 Fees
Adopted in 1980, rule 12b-1 allows mutual funds to use their assets to pay for distribution. When the rule was enacted, the idea was to allow funds to grow quickly so they could ultimately pass on savings to fundholders in the form of lower expenses. Unfortunately, that logic has proved flawed.

Also, the definition of the 12b-1 fee has become somewhat murky, and there's little clarity or agreement about what they pay for and, thus, how to define them. True, 12b-1 fees are often used as a commission to brokers for selling the fund. But as explained in this commentary, sometimes the brokers who are compensated via 12b-1 fees are providing other services to existing fund shareholders, such as administrative services. But all fees paid to brokers who distribute fund shares must legally be classified as 12b-1 fees, regardless of whether the duties they are performing are distributive or administrative in nature. The fact that 12b-1 fees are used to pay brokers who are providing clients with ongoing services is sometimes cited as the reason for funds that are closed to new investors continuing to charge 12b-1 fees.

The amount charged can vary. For instance, Columbia Acorn fund charges a 0.25% 12b-1 fee for its  A shares (LACAX), 0.75% for its  B shares (LACBX), 1.00% for its  C shares (LIACX), and no 12b-1 fees for its R share classes. The fund's annual report breaks out how much fundholders in each share class actually pay for this cost.

Independent Trustees' Compensation
There is also a line item in the annual report for compensation paid to independent trustees. For instance, according to the annual report for Gold-rated  Oakmark Fund (OAKMX) for the year ended Sept. 30, 2014, shareholders paid $398,000 in trustees' fees. A certain percentage of each fund's directors must be independent--the SEC requires a two thirds majority of independent directors in most instances, and many boards are three quarters independent. (In terms of defining "independence," the Investment Company Act of 1940 says an independent director cannot currently have, or at any time during the previous two years have had, a significant business relationship with the fund's adviser, principal underwriter (distributor), or affiliates. An independent director also cannot own any stock of the investment adviser or certain related entities, such as parent companies or subsidiaries.)

Karen Wallace does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.