When investing in mutual funds, it is important to understand the fees associated with purchasing and owning them. All mutual funds, including no-load funds, have fees. After all, mutual fund companies are just like any other business, and they make money only when they bring in more revenues than the expenses they incur for running the business. That in itself is not bad. As an investor, however, you must determine whether the cost of owning that fund is justified based on your goals.
Mutual funds list fee tables in their prospectus, so this is your best resource to determine how much it costs to own that fund. Unfortunately, most of these documents are difficult to understand for the average investor. Some of the more common fees include management, distribution (12b-1) and transaction fees:
Mutual fund companies use this fee – up to a maximum of 1 percent – to compensate brokers for recommending this investment to their clients and for keeping the money invested in that fund. These fees are relevant for brokers who receive their pay from commissions. If you have an advisory account with your financial advisor, however, then that advisor does not receive 12b-1 fees as a form of compensation. Make a point to ask your advisor if he or she receives 12b-1 fees from the mutual funds recommended for your account, as this can impact the returns that you realize over time.
Management and distribution fees are generally paid out of the mutual fund assets, and you indirectly pay for them through your investment returns.
Reinvestment fees can be assessed for buying more shares of a mutual fund each time you receive dividends, interest and capital gains. Exchange fees are sometimes charged if an investor replaces shares of one mutual fund with shares of another mutual fund that is in the same fund family.
In the mutual fund community, you are more likely to hear the general term “expense ratio.” This ratio tells you how much a fund is spending, relative to its assets, to operate the fund.
Management and distribution costs are included in this ratio, whereas transaction fees are not. While expense ratios vary widely, you should strive to keep them below 1 percent for U.S. stock mutual funds and .8 percent for bond mutual funds. Specialty funds, like those that invest in international markets or real estate, tend to be more expensive, whereas index funds can cost considerably less than actively managed counterparts.
Funds with high expense ratios need better performance than lower cost options in order to be competitive over time. Suppose you invested $100,000 in either Mutual Fund ABC with an expense ratio of .8 percent or Index Fund DEF with an expense ratio of .2 percent. If both earned an average of 7 percent over the next 20 years, you would have $333,035 or $372,756, respectively.
Neither fee may seem expensive at first glance, but they can add up to a significant amount of money over time.
Costs and fees are a natural part of doing business that you cannot avoid. Nevertheless, it is imperative to make sure that you are comfortable with the product and service that you receive for the price you pay.
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