Understanding Mutual Fund Fees & Expenses

When you invest in a mutual fund you pool your money together with other investors. Each pool of money, or fund, has a specific objective.

Think of a fund like a giant batch of cookie dough. The ingredients could be individual stocks or individual bonds depending on the objective of the fund. The fund charges a fee, called an expense ratio, to pay for the research necessary to pick the right ingredients.

The expense ratio is pinched out of the dough each year before you get your cookie. You don’t see this fee as a separate line item; you simply receive a smaller cookie because the fee charged reduced your share.

All funds charge an expense ratio. The fee varies depending on two factors:
1) The objective of the fund
2) The way the fund is marketed

Objective of the Fund
First, let’s look at the affect the fund objective has on fees. It is more expensive to research and purchase investments that are overseas or investments that are not widely followed. This means funds that have an objective of investing in stocks or bonds in the international, emerging market, small and micro cap markets will typically have higher expenses than a fund that owns all large cap U.S. investments.

In addition, many funds are actively managed and thus they have a team of research analysts trying to pick the best stocks or bonds in a particular category in an attempt to generate a return higher than a simple buy and hold strategy. Active management takes more time and generates higher expenses. Ironically enough, research has shown that in the more widely followed market segments, active funds rarely outperform their passive counterparts.

A passive fund owns all the stocks, or a relevant sample of them, in a particular segment of the market. For example, a large cap fund would own all 500 stocks listed in the S&P 500 index. This type of fund has significantly lower internal fees.

The Way the Fund is Marketed
The second factor that affects fees is the way the fund is marketed. In addition to the expense ratio, funds may have a front end sales charge, a back end sales charge or a 12b1 fee. These types of fees are used to compensate the financial advisors for selling the funds.

An “A” share fund charges a commission as high as 5.75% when you purchase shares of the fund. A “B” share fund charges a fee when you sell shares of the fund and charges an ongoing 12b1, typically 1% per year. (Even though there is not an up front sales charge, “B” share funds still provide up front compensation to the advisor who sells them.) A “C” share fund charges a 12b1 fee, usually an extra 1% per year, paid to the advisor as long as they are servicing your account.

A no-load fund does not market through commissioned financial advisors, so it has no front end sales charge, back end sales charge or 12b1 fees associated with it. No-load funds may be purchased directly from the fund or through a brokerage account, or through an independent or fee-only advisor who charges a fee to design and or manage a portfolio of no-load funds for your account.

So which way should you go? It is almost always to your benefit to select choices that leave you the most flexibility. Most people need assistance designing and managing their portfolio which means the best option would be to use a fee-only advisor who uses no-load funds.

For those comfortable designing their own portfolio, no-load funds would be the most efficient tools to use.