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One Expense Ratio to Rule Them All

What is the adjusted expense ratio, and why should you care?

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If you haven’t been distracted by pandemic fears, falling stock prices, and U.S. Treasury yields plumbing new lows, you may have come across a new data point on Morningstar.com: the adjusted expense ratio. As we’ve noted before, our analysts have long used a modified version of the prospectus net expense ratio to make cost comparisons when researching and rating funds. That figure used to be incorporated in our methodology for calculating the prospectus net expense ratio, but we launched it as a separate data point in 2019. Here’s why the adjusted expense ratio is important.

Adjusted Expense Ratio, Defined
To calculate the adjusted expense ratio, we start with the gross expense ratio reported in a fund’s prospectus, which is the percentage of fund assets expected to be paid over a year for operating expenses, management fees, and interest and dividend expenses. The net expense ratio takes that figure and removes any contractual fee waivers and reimbursements. The adjusted expense ratio further strips out interest and dividend expenses from the net figure, a step that helps provide the end investor with an apples-to-apples comparison of expense ratios across funds.

What It Solves
Removing interest and dividend expense from the expense ratio gives investors a better sense for what a fund company is charging them for the cost of running the fund. Unlike the various operating costs a fund company deducts from fund returns--such as accounting, legal, and administrative fees; distribution costs; and the compensation the firm collects for managing the portfolio--the interest and dividend costs a fund incurs are a consequence of the investment decisions made by the portfolio manager, not unlike trading costs.

Is it useful to know how much a fund is paying for investment-related costs? Of course. But not all types of transaction costs are required to be reported in the expense ratio, which means it isn’t an especially helpful tool for making transaction cost comparisons. Brokerage commissions and bid-ask spreads are not included in the expense ratio, for example, while interest on a loan is. Funds that short physical securities or enter reverse-repurchase agreement transactions are required to report interest expense, whereas funds that employ futures, swaps, TBAs, and forwards are not required to report the cost associated with those instruments as interest expenses.

These discrepancies make it possible for two funds to obtain substantially similar economic exposures using different instruments with different consequences for their expense ratios. For example, a bond manager who adjusts a fund’s duration by using the proceeds from a reverse-repurchase agreement to purchase U.S. Treasuries is required to report interest expense, but a manager who adjusts a fund’s duration using interest-rate futures or swaps is not. A fund that shorts stocks would have to report the dividends it pays on the shares it borrowed plus any interest in its expense ratio, while another fund that effectively shorts the same stocks via total return swaps would not have to report the costs of those transactions in its expense ratio.

Leaving investment-related costs in a fund’s expense ratio can complicate evaluating a fund on its own, as well. Because these costs are incurred as a result of a manager’s investment decisions, they can vary widely from year to year depending on the economic environment, market conditions, the tools involved, and the magnitude of which they're being used. If they fluctuate, including these costs in the expense ratio can make it difficult to tell whether a fund’s fees are increasing or decreasing because the fund company is hiking or cutting its regular operational costs or because the manager is making changes to the investment portfolio.

Where It Counts
Most mutual funds don’t use tools that would result in interest and dividend expenses showing up in their expense ratios. For most, the adjusted expense ratio will match its net expense ratio. However, there are some cases in which using the adjusted expense ratio is absolutely essential for making apples-to-apples cost comparisons. For example, many funds in the alternatives Morningstar Categories routinely short securities to such a large extent that their reported interest and dividend expenses can be larger, even multiples higher, than the fund’s operating costs. Vanguard Market Neutral (VMNFX) is an example we often cite: The fund’s prospectus net expense ratio of 1.80%, which includes 1.60% in dividend expenses on securities sold short, obscures the uncommonly low operating costs fund investors pay, as reflected by the adjusted operating expense ratio of 0.20%.

In bond fund categories, the differences between the adjusted and net expense ratios tend to be much smaller, but they still matter. In many cases, the difference between a bond fund qualifying as cheap or expensive versus its competitors comes down to several basis points. It’s not uncommon for bond funds that use reverse-repo transactions to incur an additional 5, 10, or 20 basis points in interest expense each year. For example, Pimco Total Return’s (PTTRX) most recent prospectus net expense ratio of 0.71% included 25 basis points of interest expense. The prior year, that figure was 0.55%, including 9 basis points of interest expense. If investors looked only at the net expense ratio, they might have assumed that Pimco hiked the fund’s fees, but the adjusted expense ratio shows that the fund’s operating costs have remained constant at 0.46%.

Municipal bond funds are another group for which the adjusted expense ratio can be important. Some funds employ tender option bond structures that are internally leveraged through the use of borrowing, and the resulting interest expense has to be reported in their expense ratios. As with other investment-related costs, these can vary significantly from one period to the next based on managers’ active positioning of their portfolios.

These are just a few examples of how including investment-related costs in expense ratios can muddy the waters when investors want to compare the fees fund managers collect across funds and over time. This is why our analysts use the adjusted expense ratio when assigning Morningstar Analyst Ratings to funds and in other cost-comparison metrics, such as the Fee Level Rank (a data point that ranks the cost of share classes versus competitors in the same distribution level). While it’s more relevant when researching some types of funds, such as alternatives and fixed income, making a habit of using it will ensure you aren’t mixing operating costs and investment-related costs when doing your own homework.

Miriam Sjoblom has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.

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