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Mutual Fund Fees: Why They Matter
By John M. Gannon
Fall 2008
Mutual funds are a popular way to invest in securities because their built-in diversification and professional management may provide certain advantages over purchasing individual stocks and bonds. But like investing in any security, investing in a mutual fund involves certain risks – including the possibility that you may lose money – as well as certain costs.
Mutual fund fees are different from the costs you typically incur when you buy or sell a stock or a bond. Since fees impact the overall return of your mutual fund investment, they matter very much. Unlike investment performance, which you cannot predict and therefore cannot control, you can directly control the mutual fund fees you pay.
Understanding Fees
All mutual funds charge fees. Small percentage differences can add up to a big dollar difference in the returns on your mutual funds, so it’s important to be aware of the fees associated with your funds. Some fees are charged on an ongoing basis and others are charged at specific times based on actions you take. The fund’s prospectus – which you should always read before investing in any fund – describes all fees in detail.
These fund fees may be charged on an ongoing basis:
Management fees. These fees pay the fund’s portfolio manager.
12b-1 fees. These fees, capped at one percent of your assets in the fund, pay for the cost of marketing and selling the fund, certain shareholder services and sometimes employee bonuses.
Other expenses. This miscellaneous category includes the costs of providing services to shareholders outside of expenses covered by 12b-1 fees or portfolio management fees. You also pay transaction fees for trades the fund makes; unlike the other fees, however, this amount is not reported separately.
The following fees are based on specific actions you may take:
Account fees. Funds may charge a separate fee to maintain your account, especially if your investment falls below a set dollar amount.
Redemption fees. To discourage short-term trading, funds often charge a redemption fee to investors who sell shares shortly after buying them. These fees may be charged anywhere from a few days to more than a year after purchase. So it’s important to understand if and how your fund assesses redemption fees before you buy, especially if you think you might need to sell your shares shortly after purchasing them.
Exchange fees. Some funds also charge exchange fees for moving your money from one fund to another fund offered by the same investment company.
Purchase fees. The fund may assess a purchase fee at the time you buy shares, even if it imposes a sales charge at the time of your original purchase (front-end load).
One easy way to compare mutual fund fees is to look for a fund’s “total annual fund operating expenses,” also known as the fund’s expense ratio. This number – which you can find in the fund’s prospectus, on the fund’s website or in financial publications – will reveal the percentage of the fund’s total assets that pays its recurring fees every year. The higher the fund’s fees, the more the fund is handicapped in trying to outperform the overall market as measured by the appropriate benchmark.
For example, if you were considering two similar funds, Fund ABC and Fund XYZ, you might want to look at their expense ratios. Suppose ABC’s expense ratio equaled 0.75 percent of assets, while XYZ’s expense ratio totaled 1.85 percent. For Fund XYZ to match Fund ABC in annual returns, it would need a portfolio that outperformed ABC by more than a full percentage point. Remember, however, that the expense ratio does not include sales charges or “loads,” fees you may pay when you buy or sell your fund.
Understanding Loads
When you buy mutual fund shares from a stockbroker or other investment professional, you may have to pay a “load,” a sales charge calculated as a percentage of the amount you invest. Like commissions on stock or bond transactions, these charges compensate the broker for the time and effort of working with you to select an appropriate investment.
The rate at which you are charged varies from fund company to fund company. In addition, companies may offer different classes of shares, which assess the charge at different times. Be sure you understand the financial consequences of choosing a specific share class before you purchase a fund.
Class A shares carry a front-end load, a commission you pay at the time you buy the shares. The average range for this type of load is between two percent and five percent, though it varies. This amount is subtracted from the total you’re investing in the fund. For example, if you invest $1,000 in a fund with a five percent front-end load, $950 of your investment would buy fund shares and $50 would go to your broker.
Class B shares impose a back-end load, which you don’t pay unless you sell your shares during the period the charge applies, usually up to seven years after purchase, though it could be longer or shorter. The load tends to drop, perhaps by a percentage point each year, and then disappears altogether. However, the annual fees the fund charges on Class B shares are higher than the fees on Class A shares. Back-end loads are also known as contingent deferred sales charges (CDSC).
Class C shares may carry a level load collected every year you hold the fund or in combination with a back-end load or CDSC, similar to B shares. Class C shares also tend to maintain higher annual fees than Class A shares, typically on a par with those that apply to Class B shares. In addition, C shares do not convert to another share class.
As their name implies, no-load funds do not impose sales charges, and you typically buy shares directly from the investment company that offers these funds. The same funds may be available, with a load, from investment professionals. While no-load funds have no sales charges, they may still charge 12b-1 fees, purchase fees, redemption fees, exchange fees and account fees in addition to the operating fees all funds charge.
Breakpoints
Load funds sometimes offer volume discounts for higher investment amounts, in much the same way that supermarkets sometimes offer economy bargains for buying certain items in bulk. In the case of funds, your front-end load, or Class A share sales charges, may be reduced if you invest a certain amount.
The amounts at which your sales charges drop are called breakpoints. The breakpoints are different for each fund, and your broker must tell you what they are and must apply breakpoints if your investment qualifies.
Breakpoint rules vary, but some funds let you qualify for breakpoints if all your investments within the same fund family – funds offered by the same fund company – add up to the breakpoint level. Some funds let the total investments made by all the members of your household count toward the breakpoint. In addition, some funds let you qualify for a breakpoint over time by adding your past investments to your new ones. You might even qualify for a breakpoint if you write a letter of intent, informing the fund that you’re planning to invest enough to qualify for the breakpoint in the future.
In short, funds can offer breakpoints any number of ways, or they may not offer them at all. Whenever you’re entitled to breakpoints, however, the fund is required to apply them to your investment.
When shopping for a mutual fund, keep in mind that fees play an important part in the overall return you receive on your investment. All other things being equal, the fund with lower fees will provide you with a greater return on investment.
Remember: All mutual funds have fees – and those fees matter!
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John Gannon is Senior Vice President of FINRA, the world’s leading private-sector provider of financial regulatory services. Visit www.saveandinvest.org, a comprehensive website to help servicemembers manage their money with confidence.
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Helpful Tool
In the “Tools and Calculators” section of FINRA’s SaveAndInvest.org/Military website, you’ll find an easy-to-use online Mutual Fund Expense Analyzer that allows you to compare expenses among funds or among different share classes of the same fund. Using a live data feed that captures expense information for thousands of funds, the Analyzer can help you understand the impact fees have on your investment over time. Once you select up to three funds, type in the amount you plan to invest and how long you plan to keep the fund. The Analyzer does the rest.
You should also be aware of transaction fees, which the mutual fund pays to a brokerage firm to execute its buy and sell orders. Those fees are not included in the expense ratio but are subtracted before the fund’s return is calculated. The more the fund buys and sells in its portfolio – reported as its turnover rate – the higher its potential transaction costs.