Financial Planning Blog

Since mutual fund expenses are such an important element in determining our long term returns, it pays investors to understand and control them as much as possible. Many, if not most, investors are at least somewhat familiar with mutual fund expense ratios. The expense ratio is a standard measure of the on-going costs to manage a mutual fund. It is the summation of various operating expenses of the fund divided by the assets managed by the fund. These costs are deducted by the fund, thus lowering the return earned by investors.

The costs included in mutual fund expense ratios are:

• Management or investment advisory fees: These are the fees paid to the team who oversees the portfolio of investments owned by the fund. It will cover their compensation, research costs, and administrative expenses. As the Motley Fool says, these costs are "necessary to make sure that the manager of the fund can be very well-dressed at all times and is able to go on good vacations."
• Marketing and distribution or 12b-1 fees: These fees go toward marketing, advertising, and rewarding intermediaries for selling a mutual fund's shares. For example, these may fund commissions to the broker who recommends and sells you the fund. Interestingly, these fees were once justified as helping investors-since if a mutual grows its assets, existing investors would benefit by future lower management and administrative expenses due to efficiencies of scale. I don't think anyone buys this argument today.
• Other operating expenses: These are administrative fees not captured in the above categories, and include legal, accounting, and transfer agent expenses, along with other services provided to shareholders. Again, according to the Motley Fool, thrifty funds can keep these costs low, but watch out for "the ones who use engraved paper, colorful graphics, and phone answers with highfalutin' accents."

(For more on mutual fund expenses and a handy table showing median expense ratios, see this Morningstar article.)

But, wait! Don't forget the other direct fees that may be deducted from your returns:

• Redemption fees: Some funds will charge a fee (up to 2%) for investors to redeem their shares. These are often only imposed on short term investors-those selling their shares after only a few months or up to a year. For long term investors, this is generally not an issue, and discouraging short term trading in a fund may lower overall costs to fund investors. Although similar, these fees are different than deferred sales loads (see below), in that redemption fees offset fund expenses, while deferred sales loads are used to pay broker commissions.
• Account service fees: Funds can impose a separate fee to maintain their accounts, although this is usually only done when accounts are below a certain value. However, for a small account these small fees can be a large percentage drag.
• Purchase fee: An additional fee to purchase fee shares in an account. This is different from a front-end sales load (see below), in that it is paid directly to the fund to offset costs, not to brokers for sales commissions.
• Exchange and/or reinvestment fees: Some fund families charge for exchanging shares between funds or for the reinvestment of dividends and distributions. Fortunately, these are not extremely common.

The expenses outlined above pertain to all mutual funds, including "no-load" funds that are the staple of cost-conscious investors. However, this list would be incomplete without mentioning the sales fees that can and should be avoided by the smart investor:

• Front end sales loads: This is a fee, calculated on the amount invested, that is immediately deducted and used to pay a sales commission to the broker who sold the fund. It is typically between 5 and 6%, although it may be lower or higher (up to 8.5%). Share classes with front end sales loads are referred to as A shares.
• Deferred sales loads: These are fees that investors pay on the "back end", or when they redeem shares in the fund. Typically, but not always, the fee is calculated based on the lesser of the value of the investor's initial investment or the value at redemption. Also, if it is a "contingent deferred sales load", these fees may decrease over a specified schedule, eventually to zero. That may sound like a good deal, but it usually isn't. This is because these "B shares" will charge a high 12b-1 marketing fee each year to compensate the selling broker. Two things are certain--your broker is going to be paid, and after you pay, you are going to be broker.

(For more on mutual fund sales charges and different fund classes see this Morningstar article.)

In Part 3, we will discuss the many hidden costs of investing in mutual funds. These costs are harder to quantify, but lower your returns just the same. In the meantime, keep in mind this bit of advice from Burton Malkiel of Princeton University, and author of a Random Walk Down Wall Street: "With mutual funds, you get what you don't pay for. The surest way to get top quartile performance from your actively managed mutual funds is to buy those funds with bottom-quartile expenses."