Mutual Funds: Understanding Costs
Fees vary alot across different mutual funds. Small differences in expenses can make a big difference in the value of your
investment over time. Bottom line: it is important to pay attention to mutual fund costs.
Every mutual
fund has fees and expenses. These are costs which lower your investment returns.
Example: Invest $1,000 in a fund. Assume a flat return of 5% before expenses. Your investment in a
fund with expenses of 1.5%, is worth roughly $1,990 after 20 years. Your investment in a fund with expenses of 0.5% is worth
more than $2,410. This is a significant 22% difference.
Where to Find Cost Info
Find the fees and expenses table near the beginning of the prospectus. Here is where the fund’s costs are laid out for you.
Use this info. It is important to understand a fund’s costs and to compare the costs of different funds.
This fees and expenses table breaks costs into two main categories:
- sales loads & transaction fees — paid when you buy, sell or exchange your shares
- ongoing expenses — paid while you are invested in the fund
More info about each type of expense is below.
Sales Loads
The first part of the fee table tells you whether the fund charges a sales load (a sales charge) on purchases, on reinvested
dividends, or on sales of shares (also called a
redemption fee).
No Load Mutual Funds
No load mutual funds do not charge a sales load. Every major fund category has no load funds. For many investors, no load
funds are the way to go.
Be aware that
even no load funds can have ongoing expenses, such as management fees, account maintenance fees and other expenses. There is no free ride.
Mutual Funds That Charge a Sales Load
A mutual fund that charges a sales load is generally using the load to cover marketing costs as well as paying a commission to the
people or firm that sells the fund to you. Sales loads do not assure superior performance. In fact, funds that charge sales
loads have not performed better on average (ignoring the loads) than no load funds.
Front-End Loads
A
front-end load is the fee you pay when you buy shares. It reduces the amount of your investment in the fund.
By law, a front-end load cannot be higher than 8.5% of your investment.
Example: Invest $1,000 in a mutual fund with a 5% front-end load. $50 goes to pay the sales charge.
$950 is invested in the fund.
Back-End Loads
A
back-end load (also called a
deferred load) is a fee you pay when you sell your shares. It is generally paid to the
brokers that sell the fund’s shares.
A back-end load usually starts out at 5% or 6% for the first year and gets smaller each year after that
until it reaches zero in, say, year six or seven of your investment. As a result, the longer you hold the investment, the lower
the back-end load.
Example: Invest $1,000 in a mutual fund with a 6% back-end load that decreases to zero in the seventh year.
Assume for this example the value of your investment remains at $1,000 for seven years. If you sell your shares in year 1, you pay
a back-end load of $60. You get back $940 (we are ignoring any gains or losses). Hold on to your shares and sell in year 7,
you get back $1,000 and pay no back-end load.
Ongoing Expenses
The second part of the fees and expenses table shows the types of ongoing expenses while you remain invested in the fund.
Expenses are generally a percentage of the fund’s assets, often for the most recent fiscal year.
Here is where the important
management fee shows up. This fee pays for managing the fund’s portfolio. Also look
for any other fees and expenses such as an
administrative fee.
Management and administrative fees are generally
unavoidable. You want to keep these relatively low. Compare several funds of a similar type to get a feel for what
"relatively low" means.
High expenses do not assure superior performance. Higher expense funds do not, on average, perform better than lower expense funds.
I do
not mean you should immediately rule out funds with relatively higher expenses. Some types of funds require extra work by its managers. These
include international stock funds, which require more sophisticated research. Also, funds that provide special services such as
toll-free telephone numbers, check-writing and automatic investment programs might also have higher expenses.
Trading or Brokerage Fees
These fees are paid to your broker and are not a function of the fund itself. Note that some brokers offer lower, or no, fees for
some families of mutual funds.
Rule 12b-1 Fee
The type of fee known as the
Rule 12b-1 fee is a type of ongoing fee that is taken out of the fund’s assets. It is
generally used to pay sales commissions to brokers and other salespeople. It can also be used to pay advertising and other
costs of promoting the fund to investors. It usually is between 0.25% and 1.00% of assets annually.
Funds with back-end loads often have higher Rule 12b-1 fees.
When comparing a fund that has a front-end load with a fund that has a back-end load, consider how long you plan to stay in the fund.
For time horizons of staying in a fund for six years or more, a front-end load may cost less than a back-end load. Even if the
back-end load falls to zero, over time you could pay more in Rule 12b-1 fees than if you had paid a front-end load.
Next: Final Tips & Red Flags
