Mutual Funds — Convenience at a High Cost

Mutual funds are big business; there are more than 10,000 mutual funds available to individual investors, each with its own investment objectives, fees, risks and benefits.

Convenience Galore

As one of the most popular types of stock market investments, mutual funds provide convenience for investors who:

don’t have a lot of money to invest, don’t have the time to spend researching their investment choices, andare not interested in or feel qualified to manage their own investments.

Through a mutual fund, you can conveniently invest in a professionally managed, diversified portfolio of stocks without plunking down a huge amount of money. You are essentially buying fractional shares and can therefore own the stocks of hundreds of companies, even with a small investment. And mutual funds offer the convenience of liquidity; it’s easy to get in and out of them.

Different Types of Mutual Funds

Mutual funds come in several different classes and each class has its own fees and expenses. The most common mutual fund classes are A, B and C for individual investors and classes I and R for institutional investors.

Class A — usually charge a front-end sales load along with a small annual 12b-1 fee. Class A will require a larger investment than Class B or C. The larger your investment, the lower your upfront load fee will be. Class A funds are best for long-term investing.

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Class B — charge a back-end sales load and a 12b-1 fee higher than that of a Class A fund. Loads typically start high and decrease over time, completely disappearing after, for example, six years. Class B funds are best for long-term investing.

Class C — charge high 12b-1 fees, may or may not charge a front-end sales load, and usually charge a back-end sales load. The back-end load will disappear completely after one or two years. Class C funds are best for short-term trading.

Class D — less common than the previous three classes, Class D are usually no-load funds without commissions; however, ongoing expenses are assessed. These expenses can vary, so investors should be aware of the operating expense ratios. Class D funds are purchased from brokerage firms, who will collect a 12b-1 fee.

Class I and Class R are set up primarily for institutional investors:

Class I — no-load funds that do not charge 12b-1 fees. They have very high initial investment requirements, perhaps $1 million or more.Class R — no-load funds that charge small 12b-1 fees. They are usually for retirement accounts, such as 401(k), 403(b) and 457.

For more information about mutual fund classes and the associated fees, see our article, on “How Many Mutual Fund Classes Are Available”.

All this convenience is not cheap.

Like any business providing a service, running a mutual fund costs money, and like any other business, the costs are passed on to the consumer. That’s you, the investor.

Fees and expenses vary from fund to fund and the amount you pay depends on the fund’s investment strategy and management. Most funds charge fees directly at the time of a transaction. Additionally, funds typically pay their regular and recurring fund-wide operating expenses out of fund assets instead of imposing these fees and charges directly on you.

Every mutual fund prospectus is required to disclose their fees, detailed as “Shareholder Fees” and/or “Annual Fund Operating Expenses.”

Typical “Shareholder Fees” include:

Sales loads — a commission to the broker who sells you the fund. The two general categories are a front-end sales load that you pay when you purchase the fund shares and a back-end or deferred sales load that you pay when you redeem (sell) your shares. FINRA does not permit mutual fund sales loads to exceed 8.5 percent.Redemption fee — fee assessed when you sell shares (usually a percentage of the redemption price).Exchange fee — some funds charge you when you transfer your shares to another fund, even if it’s within the same group of funds.Account fee — a maintenance fee, typically placed on accounts below a specific value, $10,000 for example.Purchase fee — different from the commission in the sales load, this purchase fee is paid to the fund, not the broker.

“Annual Fund Operating Expenses” include:

Management fees — fees paid out of fund assets for the fund’s investment advisor, managing the fund’s portfolio and administrative fees.Distribution (12b-1) fees — fees paid for marketing and selling fund shares, advertising, printing and mailing prospectuses, etc. FINRA enforces a 0.75 percent cap on these fees.Other expenses — this catch-all category includes shareholder service expenses, custodial fees, legal and accounting expenses, transfer agent expenses and other administrative costs.

Some funds identify themselves as “no-load” funds, which simply means they don’t charge any type of sales load. But no-load doesn’t mean no fees. A no-load fund will typically charge purchase fees, redemption fees, exchange fees and account fees.

Even very small differences in fees between funds can add up to substantial differences in your investment returns over time. Just as the “magic of compounding interest” grows your portfolio over time, the “tyranny of compounding costs” takes a huge bite out of your potential gains over time.

The difference between an expense ratio of 0.15 percent and 1.5 percent might not seem like much, but the effect of the compounding over an investment’s lifetime is enormous. After 30 years, a fund with a 1.5 percent expense ratio could provide an investor with several hundred thousand dollars less for retirement than a 0.15 percent index fund with the same growth.

The important thing to remember is that all fees directly reduce your retirement portfolio growth. A fund with high costs must perform better than a low-cost fund to generate the same returns. The chart below, published by the SEC, shows how a small difference in fees from one fund to another can add up to substantial differences in your investment returns over time:

Portfolio Value From Investing $100,000 Over 20 Years

John Bogle, founder of the Vanguard Group, reported in his 2007 classic, “The Little Book of Common Sense Investing,” that over the 25 years between 1982 and 2007, the stock market index was providing an annual return of 12.3 percent while the average fund investor was earning only 7.3 percent a year after mutual fund expenses. That’s a big chunk of returns disappearing in fees!

Bottom-line:

A fund with high costs must perform better than a low-cost fund to generate the same returns for you.The more you pay in fees and expenses, the less money you will have in your investment portfolio to compound over time — and that can have a huge effect on the size of your retirement nest egg.

For more information on investment fee types and why they matter, check out “Investment Fees Matter.”