Expense Limit

What Is an Expense Limit?

An expense limit is a limit placed on the operating expenses incurred by a mutual fund. The expense limit is expressed as a percentage of the fund's average net assets and represents a cap on the fees a shareholder may be charged. Knowing the expense limit of a fund is an important step in choosing a mutual fund as it tells an investor how much they might have to pay out of their profits.

Understanding an Expense Limit

When investing in a fund, investors are charged a fee, known as the expense ratio, that goes towards the cost of operating that fund. Expense ratios vary depending on the type of fund and what it offers. Actively managed funds have higher expense ratios than passively managed funds as they require a lot more work and intellectual input.

Expense limits are often voluntarily placed on a fund by its manager in order to relay to investors the most in expenses they will have to pay. The addition of an expense limit can make a fund more attractive to market participants as it makes them fully aware of the maximum percentage they may be charged. With an expense limit, fees will never rise above the stated percentage; however, the fund may charge under the stated limit.

Capped Funds

Funds that use an expense limit are referred to as capped funds because the limit caps the fees that shareholders can be charged.

Fund companies provide details on capped expense levels in their prospectus documents. Typically, capped expense levels will be instituted for a specified period. To renew or revise a capped expense level, the fund must obtain approval from its board of directors.

Fund companies may add, revise, or revoke expense caps at their discretion, but documentation and disclosure must be provided. Capped funds and indices adhere to a maximum level of investment per constituent. This can provide for broader dispersion and keeps a single holding from overly influencing the performance of the fund.

Expense cap changes will affect the annual return of a fund. Any increase in expense cap levels could lead to lower returns, while decreases would help to increase performance.

Investing in Capped Funds

A number of capped funds and capped indices exist in the investing market. Standard & Poor's (S&P) manages many capped indices that can be used for passive investment benchmarks. Capped indices from S&P include the following:

These funds are just a selection from Standard and Poor's. There are many other offerings out there for investors that focus on different sectors and benchmarks.

Types of Mutual Fund Fees

Mutual fund managers can charge various fees. Broadly speaking, the fees fall into two broad categories: Transaction fees paid to enter the fund (also called loads) and ongoing annual fees you pay to stay invested in the fund. The U.S Securities and Exchange Commission (SEC) does not generally limit the fees a mutual fund company can charge.

However, one exception to this is a 2% redemption fee limit in most situations. The Financial Industry Regulatory Association (FINRA) limits sales loads to 8.5%, and even lower if the fund charges other fees. FINRA also limits 12B-1 fees used to pay marketing and distribution expenses to 0.75%.