Lets say there is a fund who's value is USD 1000, its invested into Compnay A, 20 stocks worth USD 30 ea, so the value is USD 600. The balance 400 is invested into Company B, 40 stocks each worth USD 10.
The fund has floated 100 units at USD 10 ea.
The fund has various costs including but not limited to;
- Fund Manager Salary and Bonus
- Cost of Office Space
- Cost of Equipment
- Routine Running Cost
- Marketing and Sales
- Other Employees Cost
- Broker who is selling the fund
- Trading cost as the Fund has to buy / sell on Stock Market
Given all these cost, some of these are recovered from individual investor directly while buying or selling. So say for example you were to buy Fund worth USD 100, only USD 96 worth units would be allocated to you. The USD 4 would go towards expenses. So rather than getting 10 units, you would get 9.6 units in the fund.
Now other costs are directly taken out of the fund value and are not transperent to individual. This is called the expense ratio.
In the above example, if the Compnay A share is doing USD 35, and Compnay B is doing USD 12. Now the overall money with the fund is 1180. So the value of individual units should be 11.8 now. However what fund company would do it take around USD 80 toward other cost of funds. Hence the value would now be 11.
So how do the fund company take USD 80 out?
Well they do not necessarily take out the exact amount, it more like book keeping
This is done in multiple ways, depending on the situation
- Sell 2 shares of Compnay A, and 1 share of company B, Adjust excess in next round
- There are more investors who want to buy funds, take it from that
- Simply differ the recovery to appropriate time and use the above methods.
So the net effect for individual is the value getting lower. Hence its advised that if the fund ratio are high, in general its not a good sign. However this is not the sole criteria.