Are a Fund's Expenses Deducted Daily From Assets?

Can you please explain the total expense ratio for a mutual fund? For example, (OAKSX - Cramer's Take - Stockpickr)Oakmark Small Cap has a 1.45% total expense ratio. Is this a fee for managing costs? I heard 1.45% is deducted from the NAV on a daily basis. If this is true, how much would be deducted on a $1,000 investment on an annual basis? Thanks.

-- Raymond Ehrlich

Raymond,

Great question. We hear about a fund's expense ratio all the time, but few investors know exactly what it is. It's an important consideration when picking a fund.

Simply put, a fund's expense ratio is its daily operating costs, expressed as an annual percentage of its average net assets. While operating costs occur and are deducted daily, it's important to realize that the expense ratio represents a whole year's worth of these costs, not the amount deducted from the fund each day. In your case, the Oakmark Small Cap fund would deduct about $14.50 a year on a $1,000 investment.

Operating costs include compensation for the fund's manager for making investment choices and overseeing the portfolio; administration fees paid to the fund company for registering the fund and keeping it in compliance with the securities laws that govern mutual funds, including printing and distributing prospectuses, shareholder reports and individual account statements; and the cost of trading and maintaining the securities in the portfolio. In addition, some funds charge distribution, or 12b-1, fees that are included in the expense ratio. These fees are generally used to market the fund and compensate intermediaries who sell shares to the public.

"It takes money to run a fund," explains Steve Lipper, senior vice president of Lipper, which tracks the industry. "You have to pay for everything, from custodial fees -- so that somebody is in custody of the securities in the portfolio and the fund manager can't run away with the assets -- to shareholder service representatives who answer the phones."

The operating cost of each fund differs depending on the size of the fund and the types of securities the fund buys and sells. A large fund enjoys an economy of scale that can keep down the percentage of assets needed to run the fund. An international fund that trades in relatively illiquid securities on foreign exchanges will incur higher trading costs. The cheapest funds are index funds because stock-picking duties are limited to buying whatever stocks are in the index, and the securities traded are generally highly liquid and easily bought and sold.

On average, funds charge about 1.5%, or $15 for every $1,000 of assets, each year to keep the fund running, according to Lipper.

Whatever your fund's costs, the fees are deducted from your investment each day and have a direct impact on the fund's return. "An easy way to think about the expense ratio is the differential between the return on the portfolio and the investor's return," says Lipper.

Over time, higher costs can significantly lower your return on investment. All else being equal on two funds, here's how the cost can impact your bottom line on a $20,000 lump sum investment assuming an 8% annual return and reinvested dividends:

How Expenses Affect Returns*
	0.29% expense ratio	1.22% expense ratio
Initial investment	$20,000	$20,000
After 5 years	$28,994	$27,764
After 10 years	$42,033	$38,542
After 15 years	$60,936	$53,503
After 20 years	$88,339	$74,273
* Assuming 8% annual return and reinvested dividends. Source: The Vanguard Group.

Some fund fees are artificially lowered for short periods to keep the fund's cost within the competitive range. Often a fund adviser will "waive" or "cap" management fees to keep costs down and performance numbers up. Since the fee waivers can be lifted at any time without shareholder approval, it's important to find out whether the fund you buy is currently lowering fees this way. The small print under the fee table in the prospectus should note any fee waivers or caps.

Costs not covered in a fund's expense ratio include loads or sales charges that may be incurred up front when you purchase a fund or paid as you exit a fund (so-called level loads, or loads spread out over a period of years, are covered in the expense ratio as 12b-1 fees), transaction fees charged for buying and selling fund shares, or any account maintenance or low-minimum-balance fees.

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