What Is An Expense Ratio And How Does It Factor In On A Mutual Fund?

So another reader request came in yesterday asking about expense ratios; it read:

Hank, this might be a dumb question, but I’ve got different answers from different people and I thought I’d go to the source! So back to school for, Expense Ratios 101:
- I buy into Fund XYZ for $1000 on January 1, 2007.
- It has an expense ratio of 1.5%.
- It has no load deferred front or backend.
- On January 1, 2007 it is trading at $100 per share.
- So I would own 10 shares.
- From 2007 to 2008 it grows 10%
- Would my account now be worth $1100?
- Or would my account only be worth $1100 – $16.50 (1.5% of 1100) or $1083.50?

So how is the expense ratio calculated in there then? Does the fund take it out BEFORE it shows the $1100? Or do they take it out WHEN I cash it in? One guy even told me that it doesn’t matter at all and that they take the fund managers money and I don’t have to worry about the expense ratio as long as I don’t have a loaded-fund. but then how are they making money off me for it? I’m 99.93% sure that guy is wrong, but what is the definitive answer on expense ratios? Maybe I’m just confusing myself. –Jessie from Nashville

First of all Jessie, it’s not a dumb question! In the big world of finance, EVERYTHING is confusing! But in a nutshell, anytime you see a printed return on your investment (on statements, on the TV, online) the return is printed Net of Operating Expenses. So in your example if your statement shows a 10% rate of return and the mutual fund has a 1.5% expense ratio then the fund actually kicked out an 11.5% rate of return. Operating expenses are always taken out first…no matter what fund company you invest with. In your example you account would be worth $1100 at the end of the year. Does that make sense? Hope so, good question!

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