Monday, October 6, 2008

Breakdown of mutual fund fees

Disclaimer: My wife asked me to warn my readers that this post is longer and a bit more technical than usual.  However, we both agree that it contains important information and is well worth reading.

When you invest in a mutual fund, you have no way of knowing how much money you will earn from that fund.  However, you do know - or at least you should know - how much money you will pay in order to invest in that fund.  You also know that for every mutual fund, the total amount of money you earn is equal to the funds return minus the fund's expenses.  Therefore, when I am given a choice between two similar funds, one with high fees and one with low fees, I will choose the low fees every time.

I am right to do so.  Low fee funds as a whole outperform high fee funds.  Walter Updegrave at CNN Money recently compared the fifteen year track record of all large company stock funds.  The quartile of funds with the highest fees had an average annual expense ratio of 1.78% and the quartile with the lowest fees had an average annual expense ratio of .43%.  The expensive funds, over fifteen years produced an average return of 8.42%/year.  Not bad, but significantly less than the average return of 9.86%/year produced by the low cost funds.  Not surprisingly, the difference between the fees (1.35%) almost entirely accounts for the difference in performance (1.44%).

In order to make sure that you are paying reasonable fees, it is important to understand what kind of fees mutual funds charge.  All funds - even "no load" funds - charge fees.  They all have operating expenses, offices to lease, and employees to pay.  Here is a basic primer on the types of fees that mutual funds charge:

1. Annual Fees:  The following fees are annual fees.  They are taken out of your investment every year.  You will never see a bill for them nor will you see your account balance suddenly drop.  They are taken out, drip by drip, over time.

Management fee:  This fee is an annual fee that pays for the investment managers of your fund.  It pays their salaries and a few other expenses related to managing the fund's investments.  All funds have this fee.

12b-1 fee: This fee is used to pay for marketing and distribution expenses (which could include sales commissions).  By law, this fee can not be greater than .75% per year.  Not all funds charge this fee.

Expense Ratio: The annual expense ratio is the management fee plus the 12b-1 fee.

2. Sales Charge:  If a financial advisor is receiving a commission for selling a fund to you, the bulk of it will likely come from a sales charge or "load".  Not all funds charge these fees.  Funds with a sales charge, or load, are usually sold as class A, B, and C.

Class A funds charge a front end sales charge.  A front end charge is paid at the time that you purchase shares of the fund.  This fee can not be higher than 8.5%.  If you purchase $1000 of a class A fund with a 5% load, the mutual fund company will immediately keep $50 (5%) of your deposit and credit your account with $950.  You will pay this fee every time you purchase additional shares of this fund.

Class B funds charge a back end sales charge.  A back end sales charge is paid when you cash in your investment.  Some class B funds will lower the back end load for every year that you own the fund until it disappears after several years.  However, the fund will likely charge a higher 12b-1 fee until you have owned the fund long enough to eliminate the back end load.

Class C funds do not charge either a front end or back end sales charge.  However, they will likely have a much higher 12b-1 fee for as long as you own shares of the fund.

I recommend purchasing funds without sales loads.  If you do pay a load, make sure that you are getting something for your money.  That sales load you are paying is compensating the person who sold you the fund.  If you are not getting valuable advice, you should not be paying these fees.

Also, if you choose to pay a sales load, class A shares are generally the best value in the long run, followed by class B, followed by class C.

3. Other fees:

Brokerage charge:  If you chose to purchase funds through a broker (online or brick and mortar) you may be charged a brokerage fee.  This fee will be charged every time you buy or sell shares of the fund.  If you are making one large purchase it might not be a big deal.  However, if you are adding to your account every month, this type of charge can really add up.

Redemption fees: A redemption fee is a fee that you are charged when you sell shares of your fund.  It is a separate fee from a back end sales charge, limited by law to no more than 2%, and it is not charged by all funds.  Most funds that do charge this fee will charge it only if you redeem your shares within a few months of purchasing them.  Frequent trading of mutual funds can drive up management expenses so companies like to discourage this practice.

As you purchase mutual funds I would encourage you to avoid sales charges and try to minimize the management fees and 12b-1 fees that you pay.  I believe that Vanguard funds and E*Trade funds are some of the best and cheapest funds out there.  If you are looking for a good point of comparison, they are a great place to start.

2 comments:

Param said...

i believe trading expenses are outside of the management fees. please check.

RDS said...

Param,

You are correct. Thanks for pointing out my mistake. Trading costs are not included in the management fee or in any other fee paid by shareholders. However, shareholders do still foot the bill in the end.

If you are interested in trading costs, here is an interesting article on how they impact fund performance: http://www.kiplinger.com/columns/value/archive/2007/va0717.htm

RDS