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Not all mutual funds are the same, even if they have similar names. Fees and expenses can vary dramatically from one fund to another. That can cost you thousands of dollars in investment returns over the long-term. That’s why it’s mission-critical to understand mutual fund fees and expenses for beginners.
If you know what mutual fund fees and expenses are, and where they’re hiding in the fund, you can improve your investment performance just by making the right fund choices when you begin investing.
Types of Mutual Funds
There are two broad types of mutual funds: active and passive.
As the name implies, actively managed funds are those with direct human management, which attempts to outperform the general market. That performance is often dependent on the frequent trading of securities.
While it may lead to improved performance, it will certainly result in higher fees. Those fees pay for the compensation paid to the investment manager, as well as trading fees within the fund.
Passive funds are tied to an underlying index. For example, a common passive fund is one tied to the performance of the S&P 500 stock index. The fund will track the S&P 500, which means it will neither outperform or underperform it.
Fees on this type of fund are much lower because fund management is largely automated, and there are relatively few trades generating trading fees.
As such, the lowest fees will be found with passive funds.
Annual fund operating expenses
All investment funds have fees, which are necessary for the fund company to offer and operate the funds. It’s just a matter of what fees they have and how much they are. Since many funds charge multiple fees, a good strategy is to use a fund analyzer to know exactly what you pay for.
“There are great tools to understand how specific fees affect you,” advises Brian Walsh, Senior Manager for Financial Planning at SoFi. “FINRA provides a great tool, Fund Analyzer, that allows you to understand and compare the costs of owning more than 30,000 funds. Not only does it show the different types of expenses, but it does the math for you based on how much you plan to invest, when you will use the money, and rate of return.”
One of the complications with mutual fund fees and expenses – and why a good fund analyzer is so important – is that those charges take many different and sometimes confusing forms. Some examples include the following.
These are fees paid to the fund’s investments advisor or manager. They are higher on actively managed mutual funds than on index funds. The fee is paid out of the fund’s assets, and not as a direct charge to the shareholder.
12b-1 fees cover distribution expenses and shareholder service expenses. They may also include distribution fees, which cover marketing and selling fund shares, advertising, and printing and mailing of prospectuses and sales literature. Like management fees, they are paid out of the fund’s assets.
These can include any expenses not reflected in either management fees or 12b-1 fees. Examples include custodial expenses, legal and accounting expenses, transfer agent expenses, and other administrative costs.
Total annual fund operating expenses
This represents the total of a mutual fund’s annual operating expenses. It will be presented as a percentage of the fund’s average net assets.
Shareholder fees are a separate category of expenses not directly related to the fund or its management. Instead, these fees are those related to buying, holding and selling mutual funds in a brokerage account.
Loads are fees paid to brokers to compensate them for their services. They are expressed in percentages, such as 3%, 2% or 1% (3% is the typical maximum load).
Sales loads are paid at the time you purchase a mutual fund. If there is a 2% sales load, you will pay $100 for purchasing a $5,000 position in a mutual fund. Sales loads are sometimes referred to as “front-end loads” since they are charged upfront.
Some funds also have deferred sales charges, commonly known as “back-end loads.” This fee is assessed when you sell your position in a mutual fund. Deferred sales charges are often imposed to prevent investors from short-term trading of their funds. The charge may be waived if you hold the fund for a certain minimum amount of time, such as one year.
Many mutual funds today have no loads, and are referred to as “no-load funds.” Others have sales loads only, some impose only deferred sales charges, and still others have both.
For example, a fund with both front-end and back-end loads may charge 2% upon purchase, and 1% upon sale.
These are fees charged by some investment brokers when you sell a mutual fund. For example, Charles Schwab has a short-term redemption fee of $49.95. It will be charged on funds purchased through Schwab’s Mutual Fund OneSource if a position is held for 90 days or less.
Since it’s a flat fee, the impact will be greater on a $1,000 investment than it will be one for $10,000.
This fee is associated with maintaining your fund or the account that holds it. It’s charged on an annual basis but has become less common in recent years. A broker or a fund may charge an account fee on all account sizes and types, or only on those accounts with balances below a certain threshold.
The fund may charge a separate fee upon purchase of a fund that is separate from a load fee. It’s more typically charged when there is no load fee.
This fee may be imposed if you invest through a fund family. The fund may charge you a small fee if you exchange your investment in one fund for a position in another. It’s usually a small charge, but you should be aware of the fee and its amount if you plan to invest through a fund and participate in fund exchanges.
If you purchase mutual funds through a broker, you’ll typically be charged a commission. That fee can range between $10 and $75 per trade, regardless of the dollar amount of the mutual fund purchased or sold.
However, a growing number of brokers are offering a list of no-transaction fee mutual funds. You should favor these brokers if you plan to actively invest in mutual funds.
What is the impact of mutual fund costs and expenses?
Mutual fund fees and expenses, as necessary as they are, represent a reduction in the net return on investment in a fund.
For example, let’s assume you invest $10,000 for 30 years, with an average annual rate of return of 7%.
If you invest in a fund with average annual expenses and fees of 1%, you’ll be lowering your effective annual rate of return to 6%.
Over 30 years, your $10,000 investment will grow to $57,435.
Now let’s suppose you make the same investment except you choose a fund with average annual expenses and fees of 0.50%. That will lower your effective annual rate of return as well, but only to 6.5%.
Over 30 years, your $10,000 investment will grow to $66,144.
The difference over 30 years is $8,709. The entire difference will be mutual fund fees and expenses. And it can be avoided simply by choosing a comparable mutual fund that has lower fees and expenses.
How to minimize mutual fund fees and expenses
To get better control of mutual fund fees and expenses, work with one of the best brokers for mutual funds. They offer a large selection of funds, but at the lowest commissions, and often no commissions at all.
For example, Fidelity offers commission-free trades on more than 3,300 mutual funds, including their own Fidelity funds. Similarly, Schwab offers thousands of no-load, no transaction fee mutual funds, including their own Schwab Funds. Empower Funds offers more than 50 mutual funds covering a broad spectrum of asset classes, investment styles and strategies. But perhaps the top choice for mutual fund investors is Interactive Brokers. They offer 46,000 mutual funds, 18,000 of which have no transaction fees.
Still another option is to consider exchange traded funds (ETFs).
“In most cases, especially for beginners, you’re better off looking at lower-cost investments like ETFs (exchange-traded funds),” recommends Lawrence D. Sprung, CFP and Founder and Lead Wealth Advisor at Mitlin Financial. “These work similarly to mutual funds but at a fraction of the cost, in most cases. In addition, ETFs tend to be more tax efficient so they may end up saving you money on taxes if they are owned in a non-retirement account.”
If you find the process of mutual fund selection and fee analysis to be overwhelming, a financial advisor through WiserAdvisor can guide you through your choices. WiserAdvisor provides an online database of financial advisors from Fortune 500 companies as well as small independent firms. Participating advisors must pass a qualification process to be included in the network.
If you're looking for lower-cost financial advice, consider Empower. It’s a platform that mixes automated investing with human guided financial advice. And unlike many financial advisors, they will manage portfolios as small as $100,000.
Understanding mutual fund fees can boost your returns
One of the benefits of understanding mutual fund fees and expenses even as a beginner is that you can improve the long-term performance of your fund simply by choosing one with lower fees. The difference over the long-term can amount to many thousands of dollars. Choosing a fund with the lowest fees is one of the best and easiest ways to win at the mutual fund game.
How much should a beginner invest in mutual funds?
The answer to this question will be different for each beginning investor. It depends on a combination of factors, including the amount of money you have to invest, other investments you own, and your personal risk tolerance.
Mutual funds represent a long-term investment. You should not invest any funds than you expect to use within the next few years. At a minimum, you should also have sufficient funds in an emergency fund to cover between three- and six-months’ living expenses. That will avoid the need to liquidate your mutual fund at an inconvenient time, should you need the cash.
As to personal risk, it’s important to understand mutual funds do hold the potential to lose money. For that reason, you should invest no more than you are prepared to lose.
Who pays the load fee for a load fund purchase?
You, as the investor will pay the load fee on a load fund purchase. That’s why it’s important to invest in either no-load mutual funds, or those with the smallest load possible. After all, a large upfront load – such as 3% – will be an immediate reduction in the value of your investment.
What is a good operating expense ratio?
A good operating expense ratio is one that is below average for a mutual fund sector. The ratio will be different for each.
For example, while the average expense ratio for actively managed funds is 0.60%, the average for US equity funds is 0.63%, and 0.79% for sector funds. You should target funds with expense ratios that are below these averages.
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