Costs of investing in mutual funds

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Fee Structure
An individual investor choosing a mutual fund should consider not only the fund’s stated investment policy and past performance, but also its management fees and other expenses. Comparative data on virtually all important aspects of mutual funds are available in the annual reports prepared by CDA/Wiesenberger or in Morningstar’s Mutual Fund Sourcebook, which can be found in many academic and public libraries. You should be aware of four general classes of fees.

Operating expenses 

 Operating expenses are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. These expenses, usually expressed as a percentage of total assets under management, may range from 0.2% to 2%. Shareholders do not receive an explicit bill for these operating expenses; however, the expenses periodically are deducted from the assets of the fund. Shareholders pay for these expenses through the reduced value of the portfolio. The simple average of the expense ratio of equity funds in the U.S. was 1.43% in 2011. But larger funds tend to have lower expense ratios (and investors place more of their assets in lower-cost funds), so the average expense ratio weighted by assets under management is considerably smaller, .79%. In addition to operating expenses, most funds assess fees to pay for marketing and distribution costs. These charges are used primarily to pay the brokers or financial advisers who sell the funds to the public. Investors can avoid these expenses by buying shares directly from the fund sponsor, but many investors are willing to incur these distribution fees in return for the advice they may receive from their broker.

Front-end load 

 A front-end load is a commission or sales charge paid when you purchase the shares. These charges, which are used primarily to pay the brokers who sell the funds, may not exceed 8.5%, but in practice they are rarely higher than 6%. Low-load funds have loads that range up to 3% of invested funds. No-load funds have no front-end sales charges. About half of all funds today (measured by assets) are no load. Loads effectively reduce the amount of money invested. For example, each $1,000 paid for a fund with a 6% load results in a sales charge of $60 and fund investment of only $940. You need cumulativereturns of 6.4% of your net investment (60/940 5 .064) just to break even.

Back-end load 

A back-end load is a redemption, or “exit,” fee incurred when you sell your shares. Typically, funds that impose back-end loads start them at 5% or 6% and reduce them by one percentage point for every year the funds are left invested. Thus, an exit fee that starts at 6% would fall to 4% by the start of your third year. These charges are known more formally as “contingent deferred sales charges.”

12b-1 charges 

The Securities and Exchange Commission allows the managers of socalled 12b-1 funds to use fund assets to pay for distribution costs such as advertising, promotional literature including annual reports and prospectuses, and, most important, commissions paid to brokers who sell the fund to investors. These 12b-1 fees are named after the SEC rule that permits use of these plans. Funds may use annual 12b-1 charges instead of, or in addition to, front-end loads to generate the fees with which to pay brokers. As with operating expenses, investors are not explicitly billed for 12b-1 charges. Instead, the fees are deducted from the assets of the fund. Therefore, 12b-1 fees (if any) must be added to operating expenses to obtain the true annual expense ratio of the fund. The SEC now requires that all funds include in the prospectus a consolidated expense table that summarizes all relevant fees. The 12b-1 fees are limited to 1% of a fund’s average net assets per year.
 

Many funds offer “classes” which represent ownership in the same portfolio of securities, but with different combinations of fees. Typical Class A shares have front-end loads and a small 12b-1 fee, often around .25%. Class B shares rely on larger 12b-1 fees, commonly 1%, and often charge a modest back-end load. If an investor holds Class B shares for a long enough duration, typically 6–8 years, the shares often will convert into Class A shares which have lower 12b-1 fees. Class C shares generally rely on 12b-1 fees and back-end loads. These shares usually will not convert to Class A shares.

Each investor must choose the best combination of fees. Obviously, pure no-load no-fee funds distributed directly by the mutual fund group are the cheapest alternative, and these will often make the most sense for knowledgeable investors. But as we noted earlier, many investors are willing to pay for financial advice, and the commissions paid to advisers who sell these funds are the most common form of payment. Alternatively, investors may choose to hire a fee-only financial manager who charges directly for services instead of collecting commissions. These advisers can help investors select portfolios of low- or no-load funds (as well as provide other financial advice). Independent financial planners have become increasingly  important distribution channels for funds in recent years.

If you do buy a fund through a broker, the choice between paying a load and paying 12b-1 fees will depend primarily on your expected time horizon. Loads are paid only once for each purchase, whereas 12b-1 fees are paid annually. Thus, if you plan to hold your fund for a long time, a one-time load may be preferable to recurring 12b-1 charges.

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