Now that we understand the types of funds that are available (from Understanding Mutual Funds Part I) it's time to look under the hood and understand one of the most integral parts of a fund: the expense ratio. Most people do not understand what expenses are related to the funds they've invested in and how it impacts their investment dollars. The main point to keep in mind is that expenses are rarely made apparent in a statement. A mutual fund is required to give all investors an up-to-date prospectus that describes all related fees. However, it's often difficult to understand the terminology and wording used in a prospectus.

So what is an expense ratio? First off, understand that the expense ratio for each and every publicly traded mutual fund can be found at numerous web sites. Try searching online to identify the expense ratios of any mutual fund you own, or are thinking of owning. They usually are made up of the following: the management fee, 12-b1 fees and load.

The investment advisory fee or management fee is the money used to pay the manager(s) of the mutual fund. On average, this fee is about 0.5% to 1.0% annually of the fund's assets. This can also include the administrative costs of recordkeeping, mailings, maintaining a customer service line, etc. These are all necessary costs, though they vary in size from fund to fund. The next portion of the fee is the 12b-1 distribution fee. This fee ranges from 0.25% of a fund's assets up to 1.0% of the assets. Simply put, this is for marketing, advertising and distribution services related to the fund.

Finally, one of the more prominent expenses: the load. One type of load is called a front-end load or "A" share. These loads are typically a one-time charge of 5% of the investment amount. This type of fee charges all loads up front and allows the investor to leave the fund without penalties. Then there is a deferred load most commonly known as "B" class shares. These funds defer the load in smaller percentages over time charging a surrender penalty should you leave the fund prematurely. Once the surrender period is over, the shares become "A" shares with no further loads being assessed. Finally, there are level load funds, or "C" shares. These charge small front loads, and level loads every year thereafter. Although "C" class shares might look like they aren't so bad to buy initially they can end up being expensive to hold. Finally, there are also "no-load" funds that do not charge a typical sales load. Although generally these can look more appealing these types of funds sometimes will charge higher 12b-1 fees since they may not be actively sold through advisors or other financial professionals. Sometimes the key is the rate of return vs. the expense ratio. If a no-load fund is getting a 7% rate of return with no load and a loaded fund is averaging 12% rate of return it might make sense to invest in the fund with the load.

Some other concepts rather unique to a mutual fund are its turnover rate and tax implications. A fund's turnover rate basically represents the percentage of a fund's holdings that it changes every year (through the fund's sale and acquisition of equities). A managed mutual fund's turnover rate varies on the type of fund it is. For example: a small-cap growth fund will generally have a higher turnover rate than an index fund. Because buying and selling stocks costs money through commissions and spreads, a high turnover rate indicates higher costs for the fund. Also, funds that have large turnover ratios can end up distributing yearly capital gains to their shareholders and thus they have to pay taxes on these gains.

Armed with this knowledge the main thing to remember is that the returns that show for a mutual fund already take into account these expenses and show the "net return" for the fund. Knowing how much a fund charges in expenses will then allow you to make a true comparison of investments when picking between similar types.

Please note: this article does not take the place of a prospectus or investment advice from a licensed professional. Always research any particular investment before buying.