An investor who knows what he is doing knows where his money is going. For someone who wants to invest in mutual funds, it is important to know how much they cost. These costs have a direct effect on the profits and can't be ignored.
Mutual funds pay for their costs with the money that people put into them. The "expense ratio" is the ratio of the operating costs of a mutual fund to the total value of the fund's assets. It can be anywhere between 0.25 and 1.5 percent. It could even be 2 percent in some actively managed funds. Another ratio, called the "turnover ratio," affects the expense ratio.
The "turnover rate" or "turnover ratio" of a fund is the percentage of the fund's portfolio that changes each year. A fund that buys and sells stocks more often will have higher costs, so its expense ratio will be higher.
There are three parts to the costs of a mutual fund:
The fee for investment advice or the fee for running the business: This is the money that pays the salaries of the people who run the mutual funds and other people who work for them.
Costs of administration: Administrative costs are the costs that come with running the fund every day. Some of these are the costs of stationery, running customer service lines, and so on.
12b-1 Fee for Distribution: The cost of advertising, marketing, and distributing the mutual fund is covered by the 12b-1 fee. This fee is just an extra cost that does not help the investor in any way. Investors should stay away from funds with high 12b-1 fees.
The law in the US says that 12b-1 fees can't be more than 1% of an asset. Also, brokers can't get more than 0.25 percent of the assets as 12b-1 fees.
Investors should keep an eye on the expense ratios of the funds they have invested in. The expense ratio shows how much money the fund takes out of its assets every year to pay for its costs. The less the fund makes for investors, the more it costs to run.
But it's also important to think about how well the funds have done. A fund may have a higher expense ratio, but if it does better, the higher costs are more than made up for. For example, a fund with an expense ratio of 2% and a return of 15% is better than a fund with an expense ratio of 0.5% and a return of 5%.
Investors should know that comparing the returns of funds in different risk classes is not a good idea. Different types of funds have different returns based on how much risk they take to get those returns. A debt fund always has less risk than an equity fund. In the same way, you can't compare an index fund that only invests in stable index stocks, which are less risky, to a fund that invests in small companies, whose stocks are more volatile and carry more risk.
A good idea for a new investor is to stay away from funds with high expenses. The way a fund did in the past might or might not happen again, but expenses don't change much and will always cut into returns.
