Mutual funds and fees

Introduction
The operation of 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.

If the fund is sold by a broker or commissioned agent, there will be a sales charge associated with each purchase (and sometimes redemption) transaction.

Mutual funds also incur costs buying and selling securities for the fund [see Mutual Funds: Additional Costs]. Some funds cover the costs associated with an individual investor’s transactions by imposing  transaction fees and redemption charges directly on the investor at the time of the transactions. Unlike sales charges, these fees are usually paid back into the fund. This article describes these fees imposed on an individual investor.

Loads
Mutual funds that use brokers to sell their shares typically compensate the brokers. Funds may do this by imposing a fee on investors, known as a "sales load" (or "sales charge (load)"), which is paid to the selling brokers. In this respect, a sales load is like a commission investors pay when they purchase any type of security from a broker. Although sales loads most frequently are used 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 permit 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 purchase fund shares and a back-end or deferred sales load investors pay when they redeem their shares.


 * Sales Charge (Load) on Purchases


 * The category "Sales Charge (Load) on Purchases" includes sales loads that investors pay when they purchase fund shares (also known as "front-end sales loads" or "a-shares"). The key point to keep in mind about a front-end sales load is it reduces the amount available to purchase fund shares. For example, if an investor writes a $10,000 check to a fund for the purchase of fund shares, and the fund has a 5% front-end sales load, the total amount of the sales load will be $500. The $500 sales load is first deducted from the $10,000 check (and typically paid to a selling broker), and assuming no other front-end fees, the remaining $9,500 is used to purchase fund shares for the investor. Many load-funds provide for the payment of a reduced load charge for large purchases. Since the sales commission is paid at purchase, a-shares usually do not impose any additional ongoing commission fees (although some firms impose an additional 0.25% 12b-1 fee [see below] to the fund's expenses.


 * Deferred Sales Charge (Load)


 * The category "Deferred Sales Charge (Load)" refers to a sales load that investors pay when they redeem fund shares (that is, sell their shares back to the fund). You may also see this referred to as a "deferred" or "back-end" sales load. There are usually two types of backend fees share classes: b-shares, and c-shares. When an investor purchases shares that are subject to a back-end sales load rather than a front-end sales load, no sales load is deducted at purchase, and all of the investors’ money is immediately used to purchase fund shares (assuming that no other fees or charges apply at the time of purchase). For example, if an investor invests $10,000 in a fund with a 5% back-end sales load, and if there are no other "purchase fees," the entire $10,000 will be used to purchase fund shares, and the 5% sales load is not deducted until the investor redeems his or her shares, at which point the fee is deducted from the redemption proceeds.


 * The most common type of back-end sales load is the "contingent deferred sales charge(CDSC)". The amount of this type of load will depend on how long the investor holds his or her shares and typically, for b-shares, decreases to zero if the investor holds his or her 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 an investor holds his or her shares for one year, 4% if the investor holds his or her shares for two years, and so on until the load goes away completely. The 12b-1 fee assures that, regardless of when an investor liquidates shares, the full commission is paid. Usually, once the CDSC is reduced to zero, b-shares are exchanged into lower cost a-shares (which do not pay the 12b-1 fee). 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 b-shares, c-shares never convert to a-shares; the investor pays the added 1% asset charge for as long as the fund is held. The exact rate at which these fees will decline will be disclosed in the fund’s prospectus.

12b-1 Fees
The 12b-1 fee gets its name from the section in the Investment Company Act of 1940 that allows a mutual fund to pay distribution and marketing expenses out of the fund's assets.

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.

A 12b-1 fee has also been used as 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. The 12b-1 fee (0.25%) is also often used by no-load fund families to purchase "shelf space" on a brokerage's mutual fund "supermarket" platform. These funds are then sold as "no transaction fee" funds; no-load funds not paying the fee are sold with a 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. These fees are included in fund operating expenses, which are deducted from a fund’s returns each year. Full 12b-1 fee information is disclosed in a fund's prospectus.

Purchase and Redemption Fees
As fund shareholders buy and sell fund shares, investment managers of a fund must buy and purchase securities for the fund. These purchases and sales engender transaction costs. Some funds impose a transaction fee on investors purchasing and redeeming shares. These fees are usually paid back into the fund to compensate existing shareholders for the transaction costs incurred by transacting shareholders. Typically, as fund assets grow and transaction costs shrink as a percentage of fund assets, these fees are reduced and eventually eliminated.

Redemption fees can also be used to influence shareholder behavior by imposing a cost for redemptions. International stock funds often impose a 2 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.

Expense Ratios
The annual expense ratio represents recurring management fees as a percentage of a mutual fund's 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. The fund's expense ratio is taken out of the fund's assets and lower its 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, etc. These are costs that all funds have, but they vary in size from fund to fund.

Links

 * John C. Bogle Founder and Former Chairman, The Vanguard Group Financial Analysts Journal; November/December 2005 CFA Institute's "Bold Thinking on Investment Management: The FAJ 60th Anniversary Anthology,"; 2005 The Relentless Rules of Humble Arithmetic
 * John C. Bogle Founder and Former Chairman, The Vanguard Group, The World Money Show, February 2, 2005, Orlando, Florida In Investing, You Get What You Don't Pay For
 * ICI 2008 Investment Company Factbook
 * Vanguard: Account fees and minimums

Academic Papers

 * Bergstresser, Daniel B., Chalmers, John M.R. and Tufano, Peter, "Assessing the Costs and Benefits of Brokers in the Mutual Fund Industry" (October 1, 2007). AFA 2006 Boston Meetings Available at SSRN: http://ssrn.com/abstract=616981
 * Bullard, Mercer, and O'Neal, Edward S., "The Costs of Using a Broker to Select Mutual Funds" ZAG Study, (November 2006). Available at http://www.zeroalphagroup.com/studies/113006_Zero_Alpha_Group_Fund_Democracy_Index_Funds_Report.pdf
 * Fama, Eugene F. and French, Kenneth R., "Mutual Fund Performance" (August 18, 2008). Available at SSRN: http://ssrn.com/abstract=1153715
 * French, Kenneth R., "The Cost of Active Investing" (April 9, 2008). Available at SSRN: http://ssrn.com/abstract=1105775
 * Freeman, John P. and Brown, Stewart L., "Mutual Fund Advisory Fees: New Evidence and a Fair Fiduciary Duty Test"(August 20, 2008). Oklahoma Law Review, Vol. 61, p. 83, 2008. Available at SSRN: http://ssrn.com/abstract=1242642
 * Freeman, John P., "The Mutual Fund Distribution Expense Mess". Journal of Corporation Law, Vol. 32, No. 4, Summer 2007. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1030366
 * Haslem, John A., "Should the SEC Rid Mutual Fund Investors of 12b-1 Fees?" (March 31, 2008). Available at SSRN: http://ssrn.com/abstract=1114822
 * Houge, Todd and Wellman, Jay W., "The Use and Abuse of Mutual Fund Expenses" (January 31, 2006). Available at SSRN: http://ssrn.com/abstract=880463
 * Khorana, Ajay, Servaes, Henri and Tufano, Peter, "Mutual Funds Fees Around the World" (July 23, 2007). HBS Finance Working Paper No. 901023 Available at SSRN: http://ssrn.com/abstract=901023