The costs involved with purchasing a mutual fund are not always as straightforward as buying a share of stock. To buy stock, you simply pay your broker the agreed upon commission. Mutual funds may also involve a broker fee, but since these are professionally managed funds, there are other expenses involved. The fees involved vary widely across the spectrum of mutual funds, and are one of the biggest drawbacks to these kinds of investments. Sometimes fees are hidden or obscured with complex language, and critics say often the average investor does not understand everything that he or she is paying for. Mutual fund prospectuses are required to spell out their fee schedule in one or more tables that must be updated each year.
Mutual fund fees can be broken down into two broad categories:
- Ongoing annual fees to keep you invested in the fund.
- Transaction fees paid when you buy or sell shares in a fund (also known as loads).
The Expense Ratio
The ongoing expenses of a mutual fund are often summarized by the expense ratio. This is sometimes referred to as the management expense ratio (MER). These expenses are typically paid for out of fund assets and not billed to investors directly – but by reducing the returns that would’ve been received on those assets, fund investors still pay indirectly. These fees appear on the prospectus under the heading “Annual Fund Operating Expenses.” The expense ratio varies from fund to fund, but is typically composed of the following fees:
• Hiring Costs – Also known as the management fee, this cost is usually between 0.5% and 2% of assets on average. While this may sound minimal, this fee is responsible for producing mutual fund managers who remain among the nation’s top earners. Think about it for a second: 1% of 250 million (which is a small mutual fund) is $2.5 million a year for the portfolio manager! It's true that paying managers is a necessary fee for the service they provide, but these fees are paid regardless of the performance of the manager. Do high fees mean that a particular fund is high quality or generates above average returns? Not quite. In fact, research has shown repeatedly that portfolio managers simply aren’t able to beat the market on a regular basis – especially after taking fees into account that drag down the investors’ returns. The SEC even states on its website: "Higher expense funds do not, on average, perform better than lower expense funds."
• Distribution and Service (12b-1) Fees – The last part of the ongoing expense ratio (in the United States) is known as the 12b-1 Fee. This expense goes toward paying brokerage commissions and toward advertising and promoting the fund. When a portfolio manager buys or sells holdings in the mutual fund, they incur transaction costs that are passed on to investors. Funds that buy and sell frequently (that is, have a high turnover ratio) can rack up these fees much more quickly than a less active fund. 12b-1 fees also cover marketing for the fund. That's right, if you invest in a fund with a 12b-1 fee, you are paying for the fund to run commercials and sell itself! According to the SEC, the size of 12b-1 fees that funds may pay is not limited in general. But under FINRA rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75 percent of a fund’s average net assets per year. “Service fees” fall under 12b-1 and are used for marketing material or prospectuses sent to potential investors who inquire about the fund. These fees may not exceed 0.25 percent.
• Account Fees – Account fees are maintenance fees usually charged on small shareholders of a fund that fall below some minimum balance, usually a pre-set dollar amount.
• Other Expenses – “Other expenses” is a catchall category that includes anything that doesn’t fit into the above categories. These may include shareholder service expenses that are not included in the 12b-1 fees, custodial expenses, record keeping, legal expenses, accounting expenses, transfer agent expense and other administrative expenses. Some funds are excellent at minimizing these costs while others are not.
On the whole, expense ratios range from as low as 0.25% (usually for passive index funds) to as high as 2% or more for active specialty strategies. The average equity mutual fund charges around 1.3%-1.5%. You'll generally pay more for niche or international funds, which require more expertise from managers or funds that trade in illiquid markets which imply greater transaction costs.
Loads and Shareholder Fees
Loads are equivalent to sales commissions; they are fees that a fund uses to compensate brokers or other marketers for selling you the mutual fund. Shareholder fees cover the other costs associated with the transaction of buying or selling a mutual fund that are incurred directly by the fund holder. These fees appear in the prospectus under the heading “Shareholder Fees.”
• Sales Loads – These fees or the broker’s commissions are usually charged either upon purchase or else upon sale. Front-end loads are the most basic type of load: you pay the fee when you purchase the fund. If you invest $1,000 in a mutual fund with a 5% front-end load, $50 will pay for the sales charge, and $950 will be invested in the fund. Back-end loads (also known as deferred sales charges) are paid upon selling fund shares and can be a bit more complicated. In such a load structure, you pay the back-end load if you sell a fund within a certain time frame. A typical example is a 6% back-end load that decreases to 0% in the seventh year. The load is 6% if you sell in the first year, 5% in the second year, etc. If you don't sell the mutual fund until the seventh year, you don't have to pay the back-end load at all.
Many mutual funds carry some combination of a front- and back-end load. Still other funds don’t charge any up-front sales costs (or back-end) and are referred to as no-load mutual funds. A no-load fund sells its shares without a commission or sales charge. Some in the mutual fund industry will tell you that the load is the fee that pays for the service of a broker choosing the correct fund for you. According to this argument, your returns ought to be higher because the professional advice put you into a "better" fund. There is little to no evidence that shows a correlation between load funds and superior performance. In fact, when you take these fees into account, the average load fund performs worse than an otherwise equivalent no-load fund. Also, no-load fund may charge fees that are not sales loads. For example, a no-load fund is permitted to charge purchase fees, redemption fees, exchange fees, and account fees, none of which is considered to be a "sales load."
• Redemption Fee – Redemption fees are charged by some mutual funds when investors sell their fund shares (i.e. “redeem” them). This can be in addition to any back-end sales load, and is considered a separate fee by regulators. Unlike a sales load, which is used to pay brokers, a redemption fee is used to cover costs related with a shareholder’s redemption transaction and is paid directly to the fund. The SEC limits redemption fees to 2%. Closely related are exchange fees that some funds charge shareholder if they transfer to another fund within the same fund family.
• Purchase Fee – This fee, like the redemption fee, it is a charge paid up front by an investor to the fund itself to cover the cost of acquiring fund shares, and is not paid to a broker. It is therefore not considered a sales load.
All of these fees and definitions can be difficult to comprehend and calculate. Luckily, many investor tools exist that help calculate anticipated fees for those of us that don’t have the time or access to dozens of prospectuses. One such tool is Finra’s Fund Analyzer.
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