In investing, an expense ratio refers to an annual fee that an investment company will charge to cover the operating costs of managing a mutual fund. An expense ratio will typically be calculated annually by dividing a fund’s operating expenses by the average dollar value of assets under management. The expense ratio not only includes money paid to the investor or advisor, but also record-keeping, administrative fees, custodial services, taxes and accounting expenses. It may even include money used to advertise the mutual fund. Some funds have a 12b-1 fee associated with marketing and distribution cost that is included in expense ratio. A fund’s trading activity is not included in tabulating expense ratio.
The cost of operating expenses varies widely depending on the type of fund being managed. In general, index funds, in which a manager is simply following a given index, will have lower expense ratios than actively managed funds. For example, the Vanguard S&P 500 ETF, an index fund based on the S&P 500 Index, has a very low expense ratio at 0.05% annually. Actively managed funds require a team of researchers and analysts, a cost that is then passed on to the shareholder. One of the larger actively managed funds, the Fidelity Contrafund, has an expense ratio of 0.71% annually.
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