What is a mutual fund expense ratio? Well, we know that an expense ratio of a mutual fund is the fee you pay, expressed as a percentage of assets. As I’ve discussed before, generally, the expense ratio is comprised of investment management, administrative, and advertising (12b-1) expenses.[1] But, did you know there are four generally acceptable ways to disclose an expense ratio?
Before I explain, I need to provide a little background:
According to Morningstar, “FINRA Guidance" (“Material Fund Performance Sales Material”, NASD circa 2006) explains that funds are required to disclose a fund’s total annual operating expense ratio, gross of any fee waivers or expense reimbursements. In addition, funds are able to present a subsidized expense ratio, as long as it is presented in “a fair and balanced manner.” If a subsidized expense ratio is provided, the fund should also present whether the fee waivers or expense reimbursements were voluntary or mandated by contract, along with the period during which the fee waiver or expense reimbursement obligation remains in effect.[2]”
Okay, but what are “fee waivers” and “expense waivers?” These waivers, also referred to as expense offsets, expense reimbursements, etc., represent the amount the fund company waives or assumes in order to keep the fund’s actual (net) expenses low.[3] Fund companies may offer waivers to artificially reduce the expense ratio to attract investors or, as in 2008 through 2015, when the Fed Funds rate was 0.00% - 0.25%, Money Markets waived fees to keep their crediting rates above zero.
But enough background, below are the four types of expense ratios you are likely to see quoted in your investment reports.
Prospectus Gross Expense Ratio
Also known as the Total Annual Fund Operating Expense Ratio, the gross expense ratio comes from the fund’s most recent prospectus and reflects the total costs that could be charged to the investor and will vary somewhat from year to year based on operations and total fund assets. In contrast to the net expense ratio, the gross expense ratio does not reflect any fee waivers in effect during the time period.
Prospectus Net Expense Ratio
Also known as the Total Annual Fund Operating Expense Ratio Net of Reimbursements, the net expense ratio comes from the fund’s most recent prospectus. In contrast to the gross expense ratio, the net expense ratio does reflect fee waivers.
Annual Gross Expense Ratio
Also referred to as the Audited Gross Expense Ratio, the annual gross expense ratio comes from the fund’s audited annual report. This expense ratio reflect the actual fees that were charged during the time period. The gross expense ratio does not reflect any fee waivers.
Annual Net Expense Ratio
Often referred to as the Audited Expense Ratio, the annual net expense ratio comes from the fund’s audited annual report. Annual report expense ratios reflect the actual fees charged during the time period. In contrast to the gross expense ratio, the net expense ratio does reflect fee waivers.
To help illustrate these definitions and why it is important to understand the difference between the way in which these fund expenses are represented, see the example below for Schwab Government Money Market. The variance in the way the fee is represented could change the expense representation by as much as 0.15%.
|
Schwab Government Money Market Portfolio |
Expense |
|
Prospectus Gross Expense Ratio |
0.50% |
|
Prospectus Net Expense Ratio |
0.35% |
|
Annual Gross Expense Ratio |
0.50% |
|
Annual Net Expense Ratio |
0.46% |
The difference between gross and net expenses is a result of the fee waivers that the investment managers has implemented. The difference between the prospectus and annual expense ratios are based on the time period covered. The prospectus expense ratio (gross or net) reflects the current fee schedule and is a good estimate of what an investor will pay prospectively for owning the fund. The annual expense ratio (gross or net) is a backward accounting of the fees that investors paid during the most recent annual report period. Differences between the two are a result of a variety of factors, including changing fee structures, growth or decline in asset levels, etc.
You may have noticed; there is no reference to sales charges. Front-end, back-end, surrender, and late trading commissions/fees are not included in the expense ratios. These are fees you would have to pay in addition to the expense ratio. One final note (that my clients are familiar with hearing), any expense ratio does not include portfolio trading fees, so be aware of the fund’s turnover ratio, which is absorbed by the shareholders via lower investment returns.
At Multnomah Group, we prefer to quote the Prospectus Net Expense Ratio. Net because that is what we believe to be a more accurate reflection of what a participant pays and Prospectus versus Annual because the Prospectus Expense Ratio is more forward-looking versus the Annual Report Expense Ratio which is a backward accounting of fees.
Should you have any questions, please reach out to a Multnomah Group consultant.
Notes:
[1] See Morningstar Investing Glossary, Expense Ratio, http://www.morningstar.com/InvGlossary/expense_ratio.aspx.
[2] http://www.morningstar.com/InvGlossary/expense_ratio.aspx
[3] http://www.morningstar.com/InvGlossary/expense_waiver.aspx
Multnomah Group is a registered investment adviser, registered with the Securities and Exchange Commission. Any information contained herein or on Multnomah Group’s website is provided for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Multnomah Group does not provide legal or tax advice. Any views expressed herein are those of the author(s) and not necessarily those of Multnomah Group or Multnomah Group’s clients.