Mutual fund expenses

Mutual fund expenses

Mutual fund management fees

Now let's leave the general topics of market efficiency and market timing and have a look at selecting particular mutual funds.

When you invest in a mutual fund, the mutual fund management company needs to charge you money for the service the fund provides to you. Funds charge their customers in a number of ways.

First, and most common, the funds charge you a percentage of your assets that they manage. For example, if you invest in a bond fund, the fund will typically charge you an annual fee of 1 percent of your investment as a management fee.

These management fees generally aren't explicitly charged to you as line items in an account statement. Instead, they show up as reduced investment returns.

Suppose that you've invested in a money market fund and the money fund invests in securities that yield 6 percent. Because money market funds try to maintain a one dollar share price, the management fee is not taken out of your invested principal.

Instead, the yield reported by the fund reflects returns after the subtraction of management fees. So if management fees are one half of one percent, the fund's reported yield on the 6 percent securities will be 5.5 percent.

12b-1 Fee

There are other fees in addition to the management fee. Many funds also have something called a 12b-1 fee. This is a marketing fee designed to increase the size of the fund. In general, funds that charge 12b-1 fees should be avoided.

What are loads

Investors also are charged when they invest in mutual funds through something called loads. Loads are sales commissions that usually are paid to the broker or financial advisor who introduced you to the fund.

When you're dealing with loads, you may hear the phrase "front-end load" or "back-end load". Loads that are assessed when you make your initial investment are called front-end loads. Back-end loads are charged when you exit the fund. Front-end loads are the more common.

You don't have to pay loads

It's important to realize that you don't have to pay these sales loads. Although almost all mutual funds charge management fees based on a percentage of assets, not all mutual funds charge sales loads.

In general, whether you pay a load or not depends on the marketing channel for the fund and has little or nothing to do with fund performance.

If you select your own funds, invest by mail and otherwise interact directly with the fund family through a toll-free 800 line, you generally shouldn't be paying a sales load.

On the other hand, if you see a salesperson at a bank or brokerage who steers you into certain funds, you'll probably be paying a sales load of about 5 percent of your total investment in addition to ongoing management fees.

If you're just starting out or otherwise want to use an investment advisor, a sales load may be acceptable. The load is a way for the salesperson to be compensated for helping you.

But remember that commissioned salespeople may face conflicts of interest. You can invest in no-load funds and still get advice by seeking out a fee-only advisor, as I discuss in my tape on introductory personal finance.

How funds hide loads

As investors have wised up about avoiding loads, some mutual fund companies have tried to hide their loads. They still sell their funds through advisors, but you won't notice a sales load which reduces the amount of your initial investment. Instead, you may be invested in a class of the fund's shares which hides the fee paid to the salesperson.

Some mutual funds have different classes of shares like A, B, or C class. The difference between the classes is the loads and ongoing management fees assessed to each class.

For example, A class shares may have a front-end load of 5 percent. B class shares may have a back-end load of 4 percent. C class shares may have no load, but much higher ongoing management fees.

Either way, the salesperson generally is compensated by the fund up front for putting you into the fund. The fund recovers the up-front commission through either a back-end load or higher ongoing fees.

Remember, you don't have to pay loads. Some of the biggest and best mutual fund families like Vanguard don't charge any loads at all, and they have very low operating expenses. If you're a do-it-yourselfer, contact the mutual fund company directly and save.

Unearned loads on subsequent investments

Although I'm not completely against load funds, I have one big complaint with some of them. Some funds charge you a load every time you make an additional investment. Even worse, many load funds charge you loads on your reinvested money.

Amazingly, many load funds charge sales commissions on these reinvested funds even though your advisor does nothing to earn the commission. See if your fund has such a load and avoid these funds.

Also, realize that you aren't alone if you use a salesperson and pay loads. In fact, the majority of mutual fund investors pay loads.

Maybe these people value the advice they get from salespeople. Or maybe these investors just don't know that they can invest in hundreds of great no-load mutual funds simply by picking up the phone.

High expenses mean much less income to you

I probably spend more time talking about fund expenses than most financial advisors, but I feel expenses are important because they have a greater impact on your total return than you might imagine.

To many people, the difference between paying ongoing management fees of 1.5 percent versus 0.5 percent may seem trivial. "The difference is only one percent," you might say.

The difference is only 1 percent of the total assets, but the difference as a percentage of your return is quite large.

Assume you've invested in an expensive bond fund. It's securities return 7.5 percent each year and the fund has management fees of 1.5 percent. The after-expense return on the expensive fund is 6 percent. The after-expense return on a similar thrifty fund which only charges half a percent is 7 percent.

Comparing the 6 percent return with the 7 percent return shows that the thriftier fund gives you 14 percent more income each year! When viewed this way, the thriftier fund looks much more attractive. And remember, because of compounding, slight increases in total return give you much more wealth over the long run.

Arguments for expensive funds

Still, if you seek help from an advisor who is selling expensive or load funds, the advisor may tell you that, "You get what you pay for." You may get some personalized advice with the load that you otherwise won't get with a no-load, but when it comes to performance and account service, no-loads are just as good as their more expensive brethren.

Perhaps one of the biggest factors affecting a fund's expenses is the amount of money under management. Small funds, with under $50 million in assets, are simply more expensive to run. With a larger asset base, fixed costs like legal fees can be spread over a larger number of accounts, so higher expenses don't necessarily mean better service.

Also, expensive funds may be putting fees into places other than shareholder services. Over the past ten years mutual fund management companies have been extremely profitable. Chances are that higher fees are going into the investment managers' pockets rather than into improved service.