When investing in mutual funds, fees are an inevitable part of the process.
Mutual fund fees are generally divided into two categories: shareholder fees and operating expenses. Shareholder fees are incurred when you purchase load funds, redeem shares within a restricted period, or if your account balance drops below the minimum requirement.
On the other hand, operating expenses are ongoing costs that you pay simply by owning fund shares.
Asset-based fees are typically calculated daily and deducted from the fund’s net assets before any investment gains or losses are applied to your account. Since these fees are not reinvested, higher fees directly reduce your potential earnings. The more you pay in fees, the more you diminish your overall returns.
Operating expenses
Operating expenses cover the costs associated with running the fund and typically include:
- Investment management fees, which usually make up the largest portion of the total expenses
- Administrative fees
- 12b-1 fees, which are for marketing and distribution costs
Fees are generally expressed as an expense ratio, which is a percentage of the fund’s net assets, and can range from less than 0.1% to 2.75% or even higher in some cases. These fees can vary between fund companies and even among funds within the same family.
Actively managed funds typically have higher management fees compared to passively managed index funds, due to the greater time and resources required for making investment decisions and executing transactions. This is particularly true for actively managed international or global funds, which are often the most expensive.
Competitive pressure has led to some reduction in fund fees, especially among major no-load fund companies. Additionally, some funds have had to lower or clarify their fees due to legal settlements or SEC disclosure requirements.
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What you pay for?
A fund uses management fees to compensate its manager, who is responsible for selecting securities for the fund’s portfolio. The manager’s expertise is often a key factor in attracting investors to the fund.
When the management fee is based on a percentage of the fund’s assets under management, the manager benefits from increasing the fund’s value. In some cases, managers may also receive bonuses for outperforming the fund’s benchmark index, and additional performance-based payments may be awarded depending on the fund’s success.
Alternatively, some funds reduce the management fee percentage as the assets under management grow. While this does not necessarily decrease the total dollar amount of the manager’s compensation—since the base amount is larger—it can result in cost savings for individual investors.
Putting fees in prospectus
The best starting point for investigating fund fees is the fund prospectus. Each fund is required to disclose and describe both its shareholder fees and operating expenses.
Typically found in the first few pages of the prospectus, the fee table lists all charges you will incur, either directly or indirectly. However, brokerage fees for transaction expenses—the costs associated with buying and selling shares—are not reported in the prospectus, though they do impact the fund’s and your total return.
Comparing the expense ratios of funds with similar investment objectives is crucial when selecting a fund. Nevertheless, while fees significantly affect your long-term returns, choosing funds based solely on fees is as unwise as making investment decisions solely for tax reasons.
What are 12B-1 fees?
Named after a provision of the Investment Company Act of 1940, 12b-1 fees cover a fund’s marketing, distribution expenses, and certain shareholder services. According to FINRA rules, 12b-1 fees can be up to 1% of a load fund’s total assets, with no more than 0.75% allocated for marketing and distribution. Some funds use these fees to compensate brokers instead of charging a front-end load. Both load and no-load funds can use 12b-1 fees for shareholder services, with a cap of 0.25% of assets.
These fees are often controversial and may be subject to change. Proponents argue that marketing adds value by attracting new investors, while critics believe that these fees, once relevant in the early days of the mutual fund industry, may no longer be justified.
Legal fees limits
FINRA sets maximum fees for mutual funds as follows:
-
- Sales loads: Up to 8.5%
- Load fund 12b-1 fees: Up to 1% (with a maximum of 0.75% for marketing and 0.25% for shareholder services)
- No-load fund 12b-1 fees: Must be less than 0.25% for shareholder services
The SEC imposes a maximum redemption fee charge of 2%.
When selecting a fund, comparing the expense ratios of those with similar investment objectives is crucial. However, while fees significantly impact your long-term returns, choosing funds solely based on fees is as unwise as making investment decisions based solely on tax considerations.
Mutual Fund Fees. How Much Do You Pay? by Inna Rosputnia
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