Adjusted expense indicator

What Is Adjusted Expense Indicator?

The Adjusted Expense Indicator, often referred to as the Adjusted Expense Ratio, is a financial metric used primarily in the realm of investment management to provide a more refined view of an investment fund's operational costs. Unlike a standard expense ratio, which includes all regular operating expenses, the Adjusted Expense Indicator specifically excludes certain variable investment-related expenses, such as interest paid on borrowings or dividends on borrowed securities¹⁴. This adjustment aims to offer a more consistent basis for comparing the ongoing costs across different funds, particularly those that might employ varying leverage or short-selling strategies. The Securities and Exchange Commission (SEC) emphasizes that all types of fees and expenses can significantly reduce the value of a fund's investment returns over time¹³.

History and Origin

The concept of adjusting reported financial metrics stems from a broader accounting practice to provide clearer insights into a company's core operations by excluding one-time or non-recurring items. In the context of investment funds, the evolution of fee disclosure has been driven by increasing investor demand for transparency and lower costs. While standard expense ratios have long been a primary measure of fund costs, the advent of more complex investment strategies and the varying ways funds may incur expenses, particularly through activities like borrowing, led to the development of adjusted indicators. This allows for a more apples-to-apples comparison among diverse investment vehicles. The ongoing decline in average equity mutual fund expense ratios, a trend observed over decades, highlights the industry's response to investor preference for lower-cost options and the rise of index funds¹².

Key Takeaways

• The Adjusted Expense Indicator provides a more normalized view of a fund's operating costs by excluding specific variable investment expenses.
• It is particularly useful for comparing funds with different leverage or short-selling activities.
• Understanding this indicator helps investors assess the true ongoing cost burden on their investment returns.
• High fees, whether adjusted or not, can significantly erode long-term portfolio growth.
• Transparency in fund fees remains a critical focus for regulators and investors.

Formula and Calculation

The calculation of an Adjusted Expense Indicator typically starts with the total annual fund operating expenses and then subtracts specific variable expenses that are not considered part of the fund's core operational overhead for comparative purposes.

The general formula can be expressed as:

Where:

• Total Annual Operating Expenses includes management fees, administrative fees, marketing fees (like 12b-1 Fees), and other regular fund costs, typically expressed as a percentage of a fund's assets under management.
• Excluded Variable Investment Expenses specifically refer to costs such as interest expense from borrowed money or dividend expenses incurred when short-selling borrowed securities. These are expenses directly tied to specific investment strategies rather than general fund administration.

For example, if a fund has total operating expenses that include interest on borrowings, subtracting that interest would yield an adjusted figure more comparable to a fund that does not borrow.

Interpreting the Adjusted Expense Indicator

Interpreting the Adjusted Expense Indicator involves understanding its purpose: to provide a clearer, more comparable measure of a fund's ongoing operational costs by stripping out certain variable investment-related expenses¹¹. When evaluating an investment fund, a lower Adjusted Expense Indicator generally suggests greater efficiency and a smaller drag on potential investment returns.

For example, if Fund A has a high reported expense ratio due to significant borrowing costs for its strategy, while Fund B has a lower reported expense ratio without such activities, comparing their standard expense ratios might be misleading. By using the Adjusted Expense Indicator, which removes the borrowing costs from Fund A, investors can better compare the fundamental costs of managing the underlying portfolios, independent of specific leverage or short-selling tactics. This indicator helps investors and analysts identify whether a fund's higher costs are due to unique investment strategies that incur variable expenses or simply higher fixed operational overhead. It aids in due diligence and helps select funds that are genuinely cost-efficient for their intended purpose.

Hypothetical Example

Consider two hypothetical mutual funds, Fund X and Fund Y, each with $100 million in assets under management.

Fund X (Leveraged Strategy):

• Total Annual Operating Expenses: $1,500,000 (1.50% of AUM)
• Includes:
  • Management Fees: $700,000 (0.70%)
  • Administrative & Marketing Fees: $500,000 (0.50%)
  • Interest on Borrowings for Leverage: $300,000 (0.30%)

Fund Y (Non-Leveraged Strategy):

• Total Annual Operating Expenses: $1,000,000 (1.00% of AUM)
• Includes:
  • Management Fees: $700,000 (0.70%)
  • Administrative & Marketing Fees: $300,000 (0.30%)

Comparing their standard expense ratios (1.50% for Fund X vs. 1.00% for Fund Y), Fund Y appears significantly cheaper. However, Fund X's higher expense is partly due to its leveraged strategy, which incurs interest on borrowings. To find the Adjusted Expense Indicator for Fund X:

As a percentage of AUM, Fund X's Adjusted Expense Indicator is ( $1,200,000 / $100,000,000 = 0.012 ), or 1.20%.

Now, comparing Fund X's Adjusted Expense Indicator (1.20%) to Fund Y's (1.00%), the cost difference is narrower, highlighting that Fund X's core operational expenses, excluding the cost of leverage, are more competitive than a simple comparison of total expense ratios might suggest. This helps an investor understand the underlying cost of the fund's non-borrowing operations.

Practical Applications

The Adjusted Expense Indicator is a valuable tool for investors, analysts, and financial professionals in several key areas of fund analysis.

• Comparative Analysis: It enables a more equitable comparison of costs between funds employing different investment strategies, especially those that involve borrowing or short-selling. By removing the variable expenses associated with these strategies, investors can assess the underlying management and administrative efficiency of diverse funds.
• Due Diligence: Investors conducting due diligence on potential mutual fund or Exchange-Traded Fund (ETF) investments can use this indicator to drill down into the recurring costs that are truly under the fund manager's control, separate from the temporary costs of specific trading activities.
• Performance Attribution: It can help in understanding how much of a fund's performance is affected by its core operating structure versus the costs associated with its specific, often tactical, investment methods. This offers a more granular view than just assessing the overall net income.
• Regulatory Scrutiny: While not a formal regulatory requirement for all disclosures, the underlying principles of isolating variable costs can align with regulatory efforts to ensure fee transparency. For instance, the Securities and Exchange Commission (SEC) provides guidance on mutual fund fees and expenses, emphasizing how these costs reduce investor returns¹⁰. The Investment Company Institute (ICI) also tracks trends in fees, showing a long-term decline in expense ratios, driven partly by investor demand for lower costs⁹.

Limitations and Criticisms

Despite its utility, the Adjusted Expense Indicator has limitations and faces certain criticisms. The primary concern revolves around the lack of standardization in what constitutes "adjusted" expenses. Different fund providers or data aggregators might include or exclude various items, leading to inconsistencies that can confuse investors. For example, while Morningstar specifically mentions excluding interest from borrowings and dividends on borrowed securities⁸, other interpretations of "adjusted" expenses might differ. This lack of a universally accepted formula can make cross-provider comparisons challenging.

Another criticism is that while the adjustment aims to offer a clearer view of core operational costs, it might inadvertently downplay the total cost burden an investor faces. Expenses related to leveraging or short-selling, even if deemed "variable investment expenses," are still real costs that detract from investment returns. Omitting them from a primary "indicator" might lead some investors to underestimate the overall drag on their portfolio. For instance, research on alternative investments like interval funds highlights how complex fee structures, including those tied to leverage, can significantly increase a fund's effective expense ratio, sometimes "gobbling up" returns⁷.

Furthermore, the process of determining what to exclude can be subjective. Items such as depreciation or amortization might also be considered for adjustment in other "adjusted" financial metrics (like adjusted EBITDA⁶), blurring the lines between what should and should not be included in an Adjusted Expense Indicator for investment funds.

Adjusted Expense Indicator vs. Expense Ratio

The distinction between the Adjusted Expense Indicator (or Adjusted Expense Ratio) and the standard expense ratio lies in the scope of included costs. Both are key financial metrics used in fund analysis, but they serve slightly different comparative purposes.

While the standard expense ratio provides a clear, comprehensive picture of a fund's total recurring costs, the Adjusted Expense Indicator attempts to refine this view by removing certain tactical or variable costs. Confusion often arises because investors may not fully grasp which specific expenses are being "adjusted out" or why, potentially leading to an incomplete understanding of the total cost of ownership.

FAQs

What types of expenses are typically excluded from an Adjusted Expense Indicator?

An Adjusted Expense Indicator typically excludes variable investment-related expenses such as interest incurred from a fund's borrowings or dividends paid on securities that the fund has borrowed and then sold short⁴. These are distinct from routine operational costs like management fees or administrative charges.

Why is an Adjusted Expense Indicator used?

It is used to provide a more consistent basis for comparing the ongoing operational efficiency of different investment funds. By stripping out costs related to specific, often tactical, investment strategies like leverage or short selling, it allows for a clearer comparison of the fundamental costs of managing the fund's portfolio³.

How do fees, including adjusted expenses, impact my long-term investment returns?

All fees and expenses, whether adjusted or not, directly reduce your investment returns. Even small differences in fees can accumulate significantly over time, leading to substantial differences in your total portfolio value over the long term. This is why investors often prioritize funds with lower expense ratios².

Where can I find a fund's Adjusted Expense Indicator?

While the standard expense ratio is readily available in a fund's prospectus and on financial data websites, the Adjusted Expense Indicator might be less common or presented differently depending on the data provider or fund company. It is most often found in specialized fund analysis tools or reports from financial data firms like Morningstar¹.

Is a lower Adjusted Expense Indicator always better?

Generally, a lower Adjusted Expense Indicator is preferable as it indicates that less of your investment is being consumed by operational costs. However, it is crucial to consider the fund's investment strategy, its overall performance, and the benefits derived from the excluded expenses (e.g., potential for higher returns from a leveraged strategy). A higher Adjusted Expense Indicator might be acceptable if the fund's strategy consistently delivers superior risk-adjusted capital gains after all costs.