Mutual funds are among 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 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.
It is important to understand how the basic mutual fund fees and expenses work to make the best decisions when investing in mutual funds.
- With mutual funds, the two main costs to look out for are load fees and expense fees.
- Load fees are essentially commission fees applied when an investor buys or sells a given fund, but there are no-load funds that save investors on these costs.
- Expense fees, which are typically expressed as a ratio of the total investment, are annual costs paid to the people who manage and promote the fund.
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 means 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 regularly
- 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 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 what the fees are exactly 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 ratio is the percentage of the fund's assets 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 it 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.