the expense ratio including 12b 1 fees is 1 what is the rate of return for an invest 665402

Fees and Net Returns

To see how expenses can affect rate of return, consider a fund with $100 million in assets at the start of the year and with 10 million shares outstanding. The fund invests in a portfolio of stocks that provides no income but increases in value by 10%. The expense ratio, including 12b 1 fees, is 1%. What is the rate of return for an investor in the fund?

The initial NAV equals $100 million/10 million shares _ $10 per share. In the absence of expenses, fund assets would grow to $110 million and NAV would grow to $11 per share, for a 10% rate of return. However, the expense ratio of the fund is 1%. Therefore, $1 million will be deducted from the fund to pay these fees, leaving the portfolio worth only $109 million, and NAV equal to $10.90. The rate of return on the fund is only 9%, which equals the gross return on the underlying portfolio minus the total expense ratio. Fees can have a big effect on performance. Table 4.2 considers an investor who starts with $10,000 and can choose between three funds that all earn an annual 12% return on investment before fees but have different fee structures. The table shows the cumulative amount in each fund after several investment horizons. Fund Ahas total operating expenses of .5%, no load, and no 12b 1 charges. This might represent a low cost producer like Vanguard.

Fund B has no load but has 1% in management expenses and .5% in 12b 1 fees. This level of charges is fairly typical of actively managed equity funds. Finally, Fund C has 1% in management expenses, no 12b 1 charges, but assesses an 8% front end load on purchases. Note the substantial return advantage of low cost Fund A. Moreover, that differential is greater for longer investment horizons.

Although expenses can have a big impact on net investment performance, it is sometimes difficult for the investor in a mutual fund to measure true expenses accurately. This is because of the common practice of paying for some expenses in soft dollars. A portfolio manager earns soft dollar credits with a stockbroker by directing the fund’s trades to that broker. Based on those credits, the broker will pay for some of the mutual fund’s expenses, such as databases, computer hardware, or stock quotation systems. The soft dollar arrangement means that the stockbroker effectively returns part of the trading commission to the

fund. The advantage to the mutual fund is that purchases made with soft dollars are not included in the fund’s expenses, so the fund can advertise an unrealistically low expense ratio to the public. Although the fund may have paid the broker needlessly high commissions to obtain the soft dollar “rebate,” trading costs are not included in the fund’s expenses. The impact of the higher trading commission shows up instead in net investment performance. Soft dollar arrangements make it difficult for investors to compare fund expenses, and periodically these arrangements come under attack.