Mutual funds are in business first and foremost to make money for themselves; their second priority is to make money for their shareholders. For this reason, all mutual funds charge fees, and these fees come in several different varieties. Some of them are common to all mutual funds; others are charged by some but not others. Before you invest in a fund, you should look at the total of the fees and expenses that they charge.
Loads are the most talked about fees that mutual funds charge. A “load” on a mutual fund is just another way of saying that the fund charges a sales commission for purchase, sale, or both. There are funds that charge loads and there are funds that do not charge loads (known as “load funds” and “no load funds” respectively). Load funds can charge either a front-end load or a back-end load, that can range between as low as 1% and as high as 8.5%, which is the legal limit.
Front-end loads are sales commissions that are paid up front at the time of your purchase. So, if you give a fund a $10,000 investment and it charges a front-end load of 5%, then the fund will take 5% of your investment (that’s $500) and pocket it right away. Only what is left over after the load has been deducted will be invested into the fund (in this example, only $9,500 is invested in the fund from your initial $10,000 investment) Back-end loads charge their sales commissions when you sell (or “redeem”) your shares. So, when you go to redeem your shares in a fund with a back-end load you will end up receiving whatever money the shares are worth minus the sales commission.
Funds that have loads justify it by saying that it discourages frequent trading (which it does), and that it enables the fund managers to invest the money more confidently, without having to keep a large amount of cash reserves ready for redemptions. But do load funds offer superior returns in order to justify the expense of the load? There is no evidence to suggest that this is the case. However, you probably shouldn’t just disregard a mutual fund because it has a load. Loads are just one of many expenses that mutual funds charge. You may find that a mutual fund with a large load will often have much lower 12b-1 fees and management expenses than other funds. Also, if you are buying the fund for the long term, you should remember that you only need to pay the load once, upon buying or selling the fund, rather than on an ongoing basis.
Mutual funds charge management fees in order to pay for the management services used to run the fund. In other words, these fees are used to pay the salaries of the fund’s managers and analysts. Management fees usually do not amount to more than one percent of the fund’s assets, and they are significantly lower for passively-managed funds, such as index funds, than for actively-managed ones . You should remember that a high management fee in no way guarantees a more skillful management team.
12b-1 fees, also sometimes called “distribution fees”, pay for any marketing and advertising expenses that the fund incurs. They are called 12b-1 fees because that is the number of the SEC rule that allows mutual funds to charge them. No-load mutual funds often have higher 12b-1 fees because they do not charge sales commissions. You should always look at 12b-1 fees in conjunction with sales loads.
There are many other fees and expenses that a mutual fund might charge to you. There are custodian fees (charges used to pay the custodian that holds the fund’s assets), and sometimes there are even account-maintenance fees (charges used to pay for handling your account). Be sure to ask your mutual fund for a complete list of all the fees that it charges before you invest.
Besides comparing loads and 12b-1 fees, you can use a fund’s expense ratio to get a sense of the fund’s expenses. The expense ratio expresses as a percentage the amount of all operating expenses, including administrative expenses, management expenses, 12b-1 fees, etc, (but not sales loads) versus the fund’s total assets. This number should be listed in both the fund’s prospectus and its annual report.
A higher expense ratio does not necessarily mean that the fund is better managed. Larger funds typically have lower expense ratios than smaller funds because they enjoy lower transaction costs for higher volume trades. Index funds almost always have very low expense ratios since they have low management expenses and since they trade very little. On average, expense ratios are about 1.5%, which means that the average fund uses 1.5% of its assets to operate the fund.
The turnover ratio for a mutual fund can provide you with useful information about how expensive a fund is and how it is managed. Turnover ratios measure the amount of trading activity in the fund’s portfolio. They are calculated by taking all of the fund’s sales for a specified period of time (usually one year) and dividing by the fund’s total assets. This number tells you how much the fund’s portfolio has changed.
You probably will want to exercise caution when investing in a fund with a high turnover ratio. High turnover means that the fund’s manager is buying and selling very often, and, since every sale and every purchase involves a commission, this means that funds with high turnover ratios often have high expenses. Some experts recommend focusing on funds whose turnover ratio is less than 50%.