Your Guide to Understanding the Basics of Mutual Fund Fees
Mutual Fund Loads and Expense Ratios Have a Direct Impact on Your Rate of Return
Mutual funds are one of the most highly utilized investment options, owing largely to their simplified approach to diversification.
Rather than owning individual shares in a group of different companies, mutual funds allow investors to take advantage of diversified stock and other securities holdings and professional money management through the purchase of a single mutual fund share. Mutual fund companies essentially pool money from a large group of investors and invest that pooled money into several different securities. Each mutual fund share represents an investor's partial ownership in the fund and the income it produces.
There are mutual funds for almost every possible goal and economic outlook, allowing investors to tailor their investment portfolios accordingly. Just as there are costs associated with trading individual securities on the market, there are costs associated with managing a mutual fund. That's where mutual fund fees come in.
To make the best decisions when investing in mutual funds, it is important to understand how the basic mutual fund fees and expenses work.
Mutual Fund Loads
When you're buying shares of a mutual fund, one of the most important things you need to know is the amount of the fees that will be deducted from your investment or otherwise paid by you. These fees can have a real impact on the overall return you make. The higher the fees, the less of your investment earnings you get to keep.
First, there are fees that some mutual funds charge as commissions when you buy or sell a mutual fund. These fees are called loads and are calculated as a percentage of the amount you're buying or selling. A mutual fund can be:
- a front-load fund, meaning that you pay a certain percentage of your purchase as a commission upfront
- a back-load fund, meaning you pay the commission (as a percentage) when you sell all or part of your holdings in the fund
- a constant-load fund that takes out fees on a regular basis
- or a no-load fund, meaning you pay no commission. From a real rate of return standpoint, this is the only type of mutual fund the average investor should buy but they are not always available.
It's not uncommon for a load to be as high as 5.75%, so if you invested $10,000 in one of these front-load funds, you would lose $575 immediately. But back-load funds are no less painful. Either you see the fees deducted from what you thought were your earnings or, worse yet, you may lose money on your investment and still have to cough up the back-load funds when you sell.
While at first, a loaded mutual fund may be attractive in terms of its past investment performance, investment philosophy, or reputation, it is imperative to know exactly what the fees are before investing. There are excellent mutual funds with no load, such as Vanguard and Fidelity funds, and many others. Oddly enough, these funds often outperform the loaded funds.
Mutual Fund Expense Ratios
Before buying a mutual fund, you should also always investigate the fund's expense ratio. This is the percentage of the fund's assets that are deducted from earnings each year to cover the fund's operating expenses. Some funds have reasonable fees not exceeding 1%. Others can be 3% or more. These fees come right out of your earnings, so the lower the fee, the higher your real rate of return.
The expense ratio is made up of the 12b-1, which is a fee to cover the marketing of the fund to potential investors, and the management fee, which pays the salaries of the fund's managers. Not all funds charge a 12b-1 fee, but if they do, they're legally required to list it in the prospectus (the formal document offering to sell stock to the public). The average mutual fund expense ratio is between 1.3-1.5%. But as with any average, of course, there are funds whose expense ratio is less and others that are much higher.
Compare Fees Carefully
Some funds, such as Vanguard, do an excellent job of keeping fees low so that as much of the fund's income as possible is returned to the investors, not paid to the managers. Those are the types of funds you want to invest in if you're focused on keeping costs as minimal as possible. To put another fund's fees in perspective, compare them to Vanguard's.
Take time to review each fee you'll pay for the fund to understand the total cost and how that cost can compound over time if you remain in a fund for an extended period. You can research the fees and loads of any mutual funds online on sites like Morningstar. The time you invest in research and comparing fees, the more you can potentially reduce the loss of returns to those fees.