You are a smart investor, which is why people seek your advice. And because of this distinctive money management trait, you know that low expense ratios are generally correlated to superior long-term returns for mutual funds and ETFs.
But when you analyze prospective funds to add to a portfolio, do you look at gross expense ratio or do you look at net expense ratio? Or do you look at both? What’s the difference and why does it matter?
As conventional investing wisdom says, high expenses are a drag on performance. Therefore it is in the investor’s best interest, and thus your interest when managing client portfolios, to make low expense ratios a primary search criteria when buying new funds.
And this same wisdom suggests you have a full understanding of the difference between the two ways expense ratios can be expressed — gross and net.
Definition and Importance of Gross Expense Ratio
A mutual fund or ETF’s expense ratio represents the percentage of a fund’s assets that are used to pay operating expenses, management fees including 12b-1 fees, and administrative fees.
In most cases, a fund’s gross expense ratio and its net expense ratio are the same amount. But in some instances, the gross expense ratio is higher than the net expense ratio. This occurs when a portion of the gross expenses are reduced by waivers or reimbursements.
Therefore the net expense ratio represents the amount actually paid as a percentage of assets under management, while the gross is what shareholders would have paid if not for the waivers or reimbursements.
When and Why Gross Can Be Higher Than Net
High gross expense ratios, in comparison to the net, are most common in newer funds that have low assets under management. Economies of scale make it more expensive to manage small portfolios (and less expensive to run larger ones). The gross expenses are reduced by the fund company as an initial incentive to attract new investors.
What is important to understand is that these so-called waivers are not a direct expense to shareholders, but it can still have negative impact on future performance in an indirect way.
Therefore, while it is wise to seek funds with lower expenses, and thus have potential to receive a higher return on your portfolios, there is no requirement or guarantee that the waivers included in the gross expense ratio will continue forever.
What to Look For When Analyzing Expense Ratios
You should be cautious about buying funds with gross expense ratios higher than the net, especially if there is a significant difference, and even more so if you are in a fiduciary role in managing client portfolios.
In general, the greater the deviation between gross and net, the greater the potential risk to the investor. Buying a fund that has a gross expense ratio that is higher than its net is a bet that the waivers will continue and that the fund’s assets will grow large enough to eventually offset expenses with economies of scale.
But if the fund is poorly managed and therefore has difficulty attracting more assets, the expenses and waivers can become too much of a burden to the fund company and the fund may close or it may merge with a larger fund.
So if you are comparing two funds that are similar in objective, style and net expenses, but one of the funds has a higher gross expense ratio, you should lean away from that one.
Example of Analyzing Funds With Gross Expense Ratio
Let’s say you were looking for an actively-managed ETF that beat the major market indices in 2013. One such fund is Huntington US Equity Rotation Strategy (HUSE), which had a return of 34.8% in 2013, beating the S&P 500 by about two percentage points.
Barely two years old with assets under management of about $13.8 million, HUSE invests in select companies in the S&P Composite 1500 Index. While it holds some small-cap and mid-cap names, it’s average market cap makes it a large-cap fund.
Thus far in 2014, HUSE is up 4%, whereas the S&P 500 Index is up 5.6%. This is not a perfect apples-to-apples comparison because HUSE is actively-managed and more time is needed to judge the security selection skills of the fund manager. However, expenses remain a concern.
For example, HUSE has a reasonable net expense ratio of 0.95%. But if you ignored the gross expense ratio of 4.42%, you may have missed a potential red flag. Was it a factor in performance for 2014? Or did the manager just make a few minor and temporary mistakes? Either way, I wouldn’t bet my money on it. An expense ratio of 4%-plus is hard to justify for a large-cap fund.
Although not an automatic signal for sub-par future performance, the gross expense ratio can signal a potential risk that just isn’t necessary when there are much better alternatives available.
As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.