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Mutual Fund Expense Ratio Considerations

Expense ratio represents the money needed to own a mutual fund, which are also needed in order for the mutual fund to break even before it can start making profits to its shareholders. The mutual fund needs money in order to cover such expenses as salaries of fund managers and analysts, office leases, utility fees and other administrative costs. These costs should be covered first and only after this the mutual fund can start making money for its investors. The latter are the people from whose pocket the money comes out for the coverage of all operations expenses incurred by the mutual fund.

Now that you have taken the best decision and have decided to invest in a mutual fund, your choice on which one to select should be mainly determined by the expense ratio it has. For example, if mutual fund A has an expense ratio of 0.65% and mutual fund B has an expense ratio of 1.9%, you should certainly choose fund A. You should do this since fund B will have hard time beating fund A, because of the higher expense ratio it has to first compensate for. Only after it covers the expenses it will start generating profits for its investors. Even if you decide to buy shares of fund B, you will eventually feel how big a difference on your returns this choice will cause.

In order to further illustrate you how much a difference the expense ratio makes on your returns consider the case of an actively managed fund X and a passively managed fund Y. We assume that 10 years from now on the expected expenses for fund X, which charges 1.3% per year, are $1,790. This money will never reach your pocket and will be deducted from your returns. These calculations are made on the basis of a $10,000 investment on your part. On the other hand, the passively managed fund Y, charges only 0.18% per year. Thus, its 10 year expenses will amount to $260. As you can see, by choosing fund Y you will end up with more money in your account than by choosing fund X.

Finally, as it can be seen from the previous examples, a low cost mutual fund can generate you far greater returns. This is so since it starts in a more advantageous position than its actively managed counterparts due to the lower expenses it has to cover. So, we hope that we have managed to persuade you that a boring low-cost fund may make your financial future far more exciting.

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