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One important calculation used by the market to determine if a business or fund is operating efficiently and profitably is the expense ratio. In a business setting, the expense ratio is a comparison of various expenses to net sales. In a mutual fund, this is an annual calculation which shows what percent of the fund’s value is consumed by management expenses.
An expense ratio for a business can be calculated using total expenditures divided by total net sales to gain an overall picture of profitability. In addition, several separate calculations are generally made for particular costs or groups of costs. These are used by management to determine if certain departments or costs are being managed effectively. For example, a company may calculate a cost of sales ratio by dividing the cost of sales by the total sales. Other common comparisons are selling expense ratios and administrative expense ratios.
An operating expense ratio is also calculated annually for rental real estate properties. This is figured by dividing operating expenses by the gross rental income. Investors frequently look at this number to determine if the property is being managed effectively.
The calculation used for mutual funds is a management expense ratio (MER). Operating expenses include fees paid for the fund manager or advisor, legal fees, accounting, auditing, custodial service, other administrative costs, and 12b-1 fees. 12b-1 fees are marketing expenses incurred by the fund to market shares to investors. The expenses are added together, and then divided by the average value of the funds assets. The expenses are then deducted from the fund value to determine the return to the investor.
The average MER for a mutual fund is 1.5%. Actively managed funds that specialize in a particular sector of the market tend to have higher costs, while index funds, which require less management attention, have lower expenses. The calculation does not include all costs to the investor, however, because it does not include any of the sales fees, called loads, or redemption fees. Front-loaded funds charge an up-front fee, sometimes 2% of the total investment dollars, in exchange for lower annual expense ratio deductions. No-load funds do not charge an initial fee, and assess the full annual expenses against returns.
Prior to investing in a mutual fund, a consumer should carefully investigate the administrative costs of the funds. The MER is published in the fund prospectus, as well as in major newspapers and finance websites. If a fund has a 1.8% expense ratio, and shows an increase of value of 5%, the return to the investor will only be 3.2%. It is important to remember that the expenses are deducted from the fund value whether or not the fund has posted a gain or a loss for the year.
Examining the expenses and earnings on various funds is also important in deciding if it is more profitable to pay a fee for a front-loaded fund, or to purchase a no-load fund with a larger annual expense ratio. A history of the past performance can be an indicator of how high the management costs should be in the future. Another factor to consider is how long an investor intends to keep his money in the fund. If the investment is expected to be short-term, then he will probably not recoup the initial fee on a front-loaded fund. For long-term investments, the opposite may be true.