What’s in an expense ratio?

Last month’s Fund Analysis blog post, Three fundamental questions every advisor should be prepared to answer, focused on the Prospectus Net Expense Ratio and its revenue sharing components, including the 12b-1 fee.  This month, we're taking a look at two other common ratios, the Prospectus Gross Expense Ratio and Audited Net Expense Ratio, and how they compare and contrast to the Prospectus Net Expense Ratio.

So, what’s the difference between the Prospectus Net and Audited Net?  And, what’s the difference between the Prospectus Gross and Prospectus Net? Sometimes the numbers can be exactly the same, and sometimes they could be radically different.

Prospectus Net Expense Ratio vs. Audited Net Expense Ratio
The difference between Prospectus Net and Audited Net can be explained by a difference in time periods. The Audited Net is the audited fee charged during the previous fiscal year for the fund.  It can be considered a “backward-looking” number. The Prospectus Net is a “forward-looking” number and is the anticipated expense the fund company plans to charge for the upcoming fiscal year.  If the numbers are different, a comparison of the two can be conducted to see if the fund company anticipates an increase or decrease in fees charged.  Both numbers include the 12b-1 fee and other management fee or administrative costs for the fund.  They do not include any sales or transaction charges.

For fund of funds, the Audited Net and Prospectus Net will be different because two different numbers are being reported. The Audited Net will only report the wrap fee at the fund of fund level.  The Prospectus Net will report the wrap fee and the weighted average of the underlying fund expense ratios. 

Both numbers are net of any conditional waivers or temporary deductions in the expense ratios and this leads us to the second comparison.

Prospectus Net Expense Ratio vs. Prospectus Gross Expense Ratio
The difference between the two Prospectus ratios, Net and Gross, can be explained through conditional or contractual waivers or reimbursements the fund company may impose. The Prospectus Net will include the waivers or reimbursements, while the Prospectus Gross will exclude the waivers or reimbursements. 

You will typically see a waiver or reimbursement for funds with small asset bases.  For these funds, the actual fee that they are contracted to charge could be a significant percentage of the fund assets.  Therefore, they waive a percentage of the funds expenses to bring it into alignment with a “reasonable” number.  As the asset base of the fund grows, or if the contracted waiver period expires, the fund’s expenses could change. It’s important to check the fund prospectus to see if any waivers or reimbursements are in effect, and to see if this could change the expense ratio of the fund in the future.

In conclusion, no expense ratio is right for every application.  Consider the situation and intended use.  The following table may help.  For a complete definition of each expense ratio, refer to the fi360 Toolkit Help Center Glossary and look under the letter E. Each of the ratios is featured in the new Fee & Expense Report feature in the fi360 Toolkits released last month.

	Prospectus Net ER	Audited Net ER	Prospectus Gross ER
Data Source	Fund Prospectus	Audited Annual Report	Fund Prospectus
Time period	Upcoming fiscal year	Previous fiscal year	Upcoming fiscal year
12b-1 fees	Yes	Yes	Yes
Mgmt. fees	Yes	Yes	Yes
Admin./Asset-based fees	Yes	Yes	Yes
Sales/Trans. charges	No	No	No
Waivers/Reimbursements	Yes	Yes	No

Comments

[Rwohlner]

Great post, this is the best and clearest explanation of these three variations of the expense ratio that I have seen. As you know I'm a big fan of your company and consider the Toolkit to be an essential tool in my practice.

[Peggy McGillin]

This is very helpful. When comparing "all in costs" of portfolios, which expense ratio is closest to what the client will most likely be charged?

[Mlimbacher]

Glad to hear you found the post helpful Peggy.

None of the ratios listed above represent the true cost of an investment to an investor. Transaction charges, wrap fees, and other service charges should also be considered. With that being said, the prospectus net is the “more” accurate number of the three. It represents the expected charge for the fund moving forward, and also accounts for any waivers or redemptions.

[Dr Silver]

This is another excellent detailed discussion of the fund fees.

[Mcx Tips Trial]

An expense ratio is determined through an annual calculation, where a fund's operating expenses are divided by the average dollar value of its assets under management. Operating expenses are taken out of a fund's assets and lower the return to a fund's investors.
Depending on the type of fund, operating expenses vary widely. The largest component of operating expenses is the fee paid to a fund's investment manager/advisor. Other costs include record keeping, custodial services, taxes, legal expenses, and accounting and auditing fees.