Mutual funds and fees

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 describe fees and sales charges imposed on an individual mutual fund investor.

Operating a mutual fund involves many costs. All funds incur regular fund operating costs, which include investment advisory fees, marketing and distribution expenses, and custodial, transfer agency, legal, and accounting fees. The fund's expense ratio shows these (consolidated) costs.

If a broker or commissioned agent sells the fund, there is usually a sales charge for each purchase (and sometimes also for each sale). These sales charges are known as loads, and funds sold with these sales charges are load-funds; mutual funds that are directly sold to investors without sales charges are no-load funds.

Mutual funds also incur costs buying and selling securities for the fund. Some funds cover the costs associated with an individual investor’s transactions by charging transaction fees and redemption charges directly to the investor when buying or selling. Unlike sales charges, these fees are usually paid back into the fund.

Expense ratios
The annual expense ratio is a fund's recurring management fees as a percentage of a its assets. It shows what it costs the investment firm to operate the fund.

The expense ratio represents the percentage of the fund's assets that go purely toward the expense of the daily operation of the fund. It is taken out of the fund's assets, which lowers the return to investors.

The major parts of the expense ratio are the management fee and the administrative cost.
 * The investment advisory fee or management fee is the money used to pay the manager of the mutual fund.
 * Administrative costs are the costs of recordkeeping, mailings, maintaining a customer service line, and so on. These are costs that all funds have, but they vary in size from fund to fund.

Sales fees
Sales fees include front-end loads and deferred sales charges on broker-sold products; and a 12b-1 marketing fee that can be included in the expenses of both load funds and no-load funds.

Loads
Mutual funds that use brokers to sell their shares typically compensate the brokers. Funds may do this by charging investors a fee, known as a "sales load" (or "sales charge (load)"), paid to the selling brokers. In this respect, a sales load is like a commission investors pay to buy any type of security from a broker.

Although funds most commonly use sales loads to compensate outside brokers that distribute fund shares, some funds that do not use outside brokers still charge sales loads. The SEC does not limit the size of sales load a fund may charge, but the Financial Industry Regulatory Authority (FINRA) does not allow mutual fund sales loads to exceed 8.5%. The percentage is lower if a fund imposes other types of charges. Most funds do not charge the maximum.

There are two general types of sales loads: a front-end sales load investors pay when they buy fund shares; and a back-end or deferred sales load they pay to sell their shares.

Sales charge (load) on purchases
Front-end sales charges, also known as class A shares, include sales loads that investors pay to buy fund shares. The key point about a front-end sales load is it reduces the amount available to purchase fund shares.

For example, if you write a $10,000 check to a fund to buy fund shares, and the fund has a 5% front-end sales load, the sales load will be $500. The fund deducts this $500 sales load from the $10,000 check (and typically pays it to a selling broker. Assuming no other front-end fees, the remaining $9,500 purchases your fund shares.

Because the sales commission is paid at purchase, class A shares usually do not have any additional ongoing commission fees, although some firms add a further 0.25% 12b-1 fee (see below) to the fund's expenses. Many load-funds reduce their load charge for large purchases.

Deferred sales charge (load)
Deferred sales charge, sometimes referred to as a "deferred" or "back-end" sales load, refers to a sales load that investors pay when they sell fund shares.

When an investor buys shares that with a back-end sales load rather than a front-end sales load, they pay no sales load at purchase, and the fund immediately uses all of their money to purchase fund shares (assuming that no other fees or charges apply at the time).

For example, if you invests $10,000 in a fund with a 5% back-end sales load, and if there are no other "purchase fees", the fund uses your entire $10,000 to purchase fund shares. You do not pay the 5% sales load until you sell your shares, at which point the fund deducts this fee from your sale proceeds. There are usually two types of back-end fee share classes: class B shares, and class C shares.

The most common type of back-end sales load is the "contingent deferred sales charge" (CDSC). The amount of this type of load depends on how long the investor holds their shares and typically, for class B shares, decreases to zero if the investor holds their shares long enough. These fees are combined with an ongoing 1% expense fee called a 12b-1 fee (see below).

For example, a contingent deferred sales load might be 5% if you hold shares for one year, 4% if held for two years, and so on until the load goes away completely. The 12b-1 fee assures that, regardless of when you sell shares, you pay the full commission.

Usually, once the CDSC is reduced to zero, the fund exchanges class B shares into lower cost class A shares (which pay a lower 12b-1 fee or none). Class C shares are sold with a 1% CDSC for the first year, plus a 1% 12b-1 fee. The redemption fee is eliminated during year two. Unlike class B shares, class C shares never convert to A shares; investors pay the added 1% asset charge for as long as the fund is held. The fund's prospectus will show exact rate at which these fees will decline.

12b-1 fees
The 12b-1 fee gets its name from the section in the Investment Company Act of 1940, which lets a mutual fund to pay distribution and marketing expenses out of the fund's assets. The fund's operating expenses include these fees, and the fund deducts them from its returns each year. A fund's prospectus shows full 12b-1 fee information.

The original intent of a 12b-1 fee was to help market the mutual fund so that its assets would increase. An increase in assets should provide better economies of scale, providing investors with lower annual operational expenses.

Unfortunately, some funds use a 12b-1 fee a hidden way to pay brokers for using the fund. The SEC has limited the 12b-1 fee to 1% annually with maximum of 0.25% going to brokers. No-load fund families often use the 12b-1 fee (0.25%) to purchase "shelf space" on a brokerage's mutual fund "supermarket" platform. The platform then sells these funds as "no transaction fee" funds, but sells no-load funds not paying the fee with an added sales purchase fee. One way to avoid paying unnecessary fees is to only purchase no-load funds. A genuine no-load fund does not have 12b-1 fees, although a fund is allowed to claim it is a "no-load fund" as long as its 12b-1 fee is 0.25% or less per year. No load funds that do not charge 12b-1 fees are often called 100% no-load or true no-load funds.

Purchase and redemption fees
As fund shareholders buy and sell fund shares, the fund's investment managers must buy and purchase securities for the fund. These purchases and sales have transaction costs. Some funds impose a transaction fee on investors buying and selling shares. These fees are usually paid back into the fund, to compensate existing shareholders for the costs incurred by transacting shareholders. Typically, as fund assets grow and transaction costs shrink as a percentage of fund assets, the fund reduces and eventually eliminates these fees.

Funds can also use redemption fees to influence shareholder behavior by imposing a cost for redemptions. International stock funds often impose a two month redemption fee on sales as a means of discouraging short term arbitrage trading between time zone differentials in opening and closing price levels. Tax-managed funds also may impose redemption fees as a means of discouraging shareholder turnover.

The effect of high costs
Figure 1 shows the investment growth of both a low-cost and a typical high-cost fund.

Both funds assume an initial $10,000 investment and 8% annual growth. The time period is 30 years.

The low-cost fund is no-load and has expenses of 0.2% per year and has an initial value of $10,000. With annual expenses of 0.2% (growth of 7.8% = 8.0 % - 0.20%), the resulting fund value at year 30 is $95,184.

The high-cost fund has an initial 5.75% sales load, expenses of 2.0% per year, and a 0.25% 12b-1 fee. The initial value is $9,425.00 (10,000 - 5.75%). With annual expenses of 2.25% (growth of 5.75% = 8.00% - 2.0% - 0.25%), the resulting fund value at year 30 is $50,430.

The difference between these funds over 30 years is $44,753.