Most investors have heard of mutual funds, but relatively few understand how these funds really work. This is not surprising; after all, most people are not financial experts, and there are plenty of other things going on in their lives more urgent than the structure of fund companies. But some investors might make better decisions if they understood that mutual fund companies make money by charging them fees, and the size and type of charged fees vary from fund to fund. Mutual funds primarily make money through sales charges that work like commissions and by charging investors a percentage of assets under management (AUM).
The Securities and Exchange Commission (SEC) requires a fund company to disclose shareholder fees and operating expenses in its fund prospectus. Investors can find this information in the fee table situated near the front of the prospectus. Fees are easily the largest source of revenue for basic mutual fund companies, though some companies may make separate investments of their own. Different kinds of fees include purchase fees, sales charges, or the mutual fund load; deferred sales charges; redemption fees; account fees; and exchange fees.
- Mutual funds make money by charging investors a percentage of assets under management and may also charge a sales commission (load) upon fund purchase or redemption.
- Fund fees, called the expense ratio, can range from close to 0% to more than 2% depending on the fund's operating costs and investment style.
- Fund fees must be disclosed in its prospectus and made transparent to current or potential investors.
Understanding Mutual Funds
Mutual funds are among the most popular and successful investment vehicles, thanks to their combination of flexibility, low cost, and the chance for high returns. Investing in a mutual fund is different than simply packing money into a savings account or a certificate of deposit (CD) at a bank. When you invest in a mutual fund, you are actually buying shares of stock in a company.
The company you are buying is an investment firm. Mutual funds are in the business of investing in securities, much like Ford is in the business of making cars. The assets for a mutual fund are different, but the ultimate goal of each company is to make money for shareholders.
Shareholders make money in one of three ways. The first way is to see a return from the interest and dividend payments off of the fund's underlying holdings. Investors can also make money based on trades made by management; if a mutual fund earns capital gains from a trade, it is legally obligated to pass on the profits to shareholders. This is known as a capital gains distribution. The last way is through standard asset appreciation, which means the value of the mutual fund shares increases.
Fund companies can attach an assortment of fees to their services and products, but where and how those fees are included makes a difference. Sales charge fees, more commonly referred to as loads, are triggered by the purchase of mutual fund shares by an investor. This means the investor pays an additional percentage, something like 5% usually, on top of the actual price of the share. Fund companies do not typically retain the entire sales charges since a large portion often goes to the brokers and advisors who sold the fund.
There are different kinds of fund loads. The most common is the front-end load, which is immediately deducted from the investment amount before the shares are actually purchased. The Financial Industry Regulatory Authority (FINRA) sets an 8.5% cap on front-end loads. For example, a $1,000 investment with a front-end load sends $50 to the broker and $950 to purchase shares of the mutual fund.
There are also back-end loads that can be charged when the shares are sold. The most common of these is called the contingent deferred sales charge(CDSC). This load starts relatively high and tends to decrease over time, usually dropping to zero after a period of seven to 10 years.
Some fund companies charge purchase fees or redemption fees. These sound a lot like sales charges but are actually paid entirely to the fund, not the broker. Purchase fees take place at the time the shares are bought, and redemption fees take place at the time of shares are sold.
In essence, management fees are highly dependent on the success of the fund and the continued trading of new shares by the public. The most successful funds see a lot of new money and tend to be highly liquid; more trading equals more fee income for the company.
Annual Fund Operating Expenses
Mutual fund companies do not operate for free; there are expenses that need to be recouped. These cover costs such as paying the investment advisor, the administrative staff, fund research analysts, distribution fees, and other costs of operation.
Management fees are paid out of the fund's assets rather than charged directly to the shareholders. The SEC requires management fees to be listed as a separate item and not lumped in with the "other" expenses category, so investors can always keep track of which funds are spending the most on management compensation.
Most investors end up hearing about distribution fees, more commonly referred to as 12b-1 fees. Capped at 1% of your fund assets, 12b-1 fees are charged to shareholders to recoup costs associated with marketing the fund and providing shareholder services. A lot of these fund costs are necessary; for example, the SEC requires the printing and distribution of prospectuses to new investors. As the mutual fund space has become more competitive, particularly since the late 1990s, 12b-1 fees have narrowed, and shareholders have become more sensitive to them.
12b-1 fees change from share class to share class. Class A shares tend to impose front-end loads and have lower 12b-1 costs, and some mutual funds reduce the front-end load based on the size of the investment. This is known as "breakpoints" in the industry. The idea is the mutual fund company is willing to sacrifice some revenue on a per-share basis to entice more share purchases. Class B shares and Class C shares tend to have higher annual expenses than Class A shares.
Many mutual funds do not have sales charges; they are called no-load funds. This doesn't mean they are free of fees, however. They may still defray marketing and distribution expenses through 12b-1 fees, though the SEC does not let these companies refer to themselves as no-load if 12b-1 expenses exceed 0.25%. Others, such as the Vanguard family of funds, do not have sales charges or 12b-1 fees at all.
No-load funds can still earn revenue from other kinds of fee income, but these companies also tend to reduce costs to compensate for the lack of sales charge income. This often correlates to less active investment management and a more passive investment strategy for the fund.