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The smart investor knows where his money is going. For an investor of mutual funds, it is necessary to understand it expenses. These expenses have a direct impact on the funds’ performance and should not be overlooked.

All mutual funds have certain expenses that are met from the capital invested in their funds. The ratio of expenses associated with the operation of the mutual fund to the total assets of the fund is called the “Expense Ratio”. The Expense ratio varies from 0.25% to 1.5%. In some actively managed funds it may be as high as 2%. The expense ratio is usually dependant on the “turnover ratio”.

The turnover rate or the turnover ratio of a fund is the percentage of the fund’s portfolio that changes every year. If a fund has high turnover rate – that is if it sells and buys stocks more frequently then obviously its expenses will go up and so will it’s expense ratio.

The expenses for a mutual fund have three components:

-The “Investment Advisory Fee” or “Management Fee” is the money that goes to pay the salaries of the fund managers and other employees of the mutual fund.

-Administrative costs are the costs associated with the daily work of the fund like stationery costs, cost of maintaining customer help-lines etc.

-12b-1 Distribution fee is the cost associated with advertising, marketing and distribution of the fund. It has no benefit for the investor and one should avoid funds in which a large amount of the expenses go to the 12b-1 fee. By law the annual 12b-1 fee cannot be greater than 1% of the fund’s assets. Also not more than 0.25% can be paid to brokers.

For an investor there is an additional cost associated with investing in certain mutual funds – “load.” Load is the commissions that mutual funds take when a customer buys or redeems shares of a fund.

It is important to keep an eye on the expense ratio of your funds as it indicates how much the fund withdraws from its assets every year to cover its expenses. The higher the expense ratio the lower will be your returns. At the same time it is essential to keep the returns in mind too – A fund have 2% expense ratio and giving 12% returns is far better than a fund (of similar class) having an expense ratio of 1% and giving 6% returns.

Note: Do not compare returns of funds in different risk classes. Returns of different classes of funds vary greatly because of the risk associated with different types of funds. An equity fund has a greater risk associated with it and therefore cannot be compared with a debt fund. Similarly an index fund investing only in index stocks which are relatively stable and less risky cannot be compared with a fund which invests in stocks of small companies – a high risk investment.

Avoiding funds with high expense ratios is not a bad idea. One cannot be sure that the past performance of the fund will be repeated in the future, but the expenses of the fund are more or less certain for the future too.