'Expense Ratio' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Expense ratio relates to the costs that a mutual fund incurs as it trades and does normal business. Typical mutual fund expense ratios include a number of different costs. Among these are management fees, transaction costs, custody costs, marketing fees, legal expenses, and transfer agent fees.
Management fees comprise those charges that the fund pays to the company which handles the portfolio management. They invest the fund’s money as per the direction of the mutual fund board of directors. Management costs are typically the largest single portion of the mutual fund’s expenses.
These fees commonly range from as little as .5% to as much as 2%. Lower fees are usually more advantageous for investors. This is because every dollar that goes to the management of the fund is not increasing the share holders’ wealth. Some mutual fund types charge a higher amount in fees. International or global mutual funds will usually cost more than simple domestic market mutual funds. They justify these greater charges by the difficulty of managing an international portfolio.
Transaction costs include the fees that the fund pays to stock brokers. These are negotiated to extremely low rates such as a penny per share or even lower thanks to the enormous volumes that mutual funds trade. Those funds that are constantly purchasing and selling investments create significantly greater transacting costs for themselves and their investors. Higher turnover rates like this also can lead to larger capital gains taxes and other costs.
The investment holdings of a mutual fund must be kept by a custodian bank. This creates custody costs where these banks register the bonds, stocks, and other investments for the fund. Some of the banks do this electronically and others keep actual stock certificates in their vault storage.
Custodian banks also collect interest and dividend payments, maintain accounting for the various positions so gain/loss info is readily available to management, and handle stock splits and other transaction issues. These custodian costs prove to be a less significant percentage of expense ratios for the mutual funds.
Marketing fees for mutual funds come out of the money that the investors pool. This money is utilized to advertise the fund so they can raise additional investment dollars. More money in the fund means more management fees for the portfolio managers. These 12b-1 marketing fees are money that does not benefit an investor after the fund exceeds $100 million in net assets. A very small number of brokers actually refund such fees to their investors.
There are some legal expenses that mutual funds must incur in the course of normal operating business. These include for paperwork they are required by law to file for regulators like the SEC, specific licenses, incorporation, and other legal procedures. The majority of funds count such costs as a small amount of their overall expense ratio.
Transfer agent costs cover the expenses that arise when a shareholder cashes out or buys into the fund. Transfer agents must handle various account statements, paperwork, and money in the process. These agents take care of all the mundane daily paperwork for purchases, redemptions, and processing which keep the fund and other capital markets working.
There are various other costs that are not included in the mutual fund expense ratio but many experts feel should be. These include mutual fund sales loads. These fees are simply commissions that go into the pocket of the institution, company, or stockbroker that persuaded you to buy the mutual fund in the first place. Because of these and other high costs of many mutual fund expense ratios, some people prefer low cost index funds that involve very low management costs.