One of the most important criteria in choosing a mutual fund is the fees they charge. The reason fees are so important to avoid is because they reduce your rate of return. Instead of this money going into your account, it gets siphoned off to the fund company or a financial adviser. Just two more percentage points over a long period of time could double or triple the amount in your retirement fund. Fees are the enemy of compounding.
This is the fourth in a series of five posts on mutual funds.
Disclaimer: I’m not an investment professional nor am I licensed to sell securities. This information is provided for entertainment purposes. Before investing, you should seek the advice of an investment professional. I’m not affiliated with nor do I receive compensation from mutual fund companies.
Management fees are charged by mutual fund companies to cover their operating expenses. Fund companies have expensive trading and accounting operations, customer service departments and websites to maintain. All of this is funded by the management fees collected from the fund holders.
These fees are collected on a daily basis and the NAV (share price) of a fund is reduced after the fees are taken out. Typical management fees can range from about .25-2.5% annually. This is commonly known as the MER or Management Expense Ratio.
Fund companies that charge higher fees often try to justify them by claiming superior performance to other funds in their class. But, statistics show clearly the funds with the lowest fees offer the highest returns, on average. Excessive fees should be avoided at all costs.
The first and most important decision you should make is whether or not to use a financial adviser to choose a mutual fund. Although an adviser can be a big help in choosing a fund and rolling over a 401K, this advice will cost you in the way of higher fees. To be fair to financial advisers, they have to make a living for providing their advice. And, they can be helpful to some people who have complex financial, tax or estate needs.
When it comes to mutual funds, I generally recommend you pick your own funds and keep the fees to a minimum. If you aren’t confident in picking a fund, you can always select an Index fund that has low fees. Or, you can pay a fee-based advisor to help you select a fund and then buy it yourself.
Some funds have different share classes, depending on whether you choose it yourself or it is selected for you by a financial adviser. Adviser Class funds charge a higher MER in order to pay a sales commission to the adviser. Adviser Class funds may even have two or three different levels of fees (B & C shares), depending on the option the financial advisor chooses. Investor Class funds have a lower MER because they don’t have to pay any commissions. The difference between A, B & C shares can be as high as 3% per year.
|Investor||A||For investors who choose their own funds|
|Adviser||B & C||For investors who use a Financial Adviser|
When I first started investing in mutual funds, it was common for funds to have a sales load. In fact, some of these loads were pretty high. My first mutual fund had an 8.5% front-end load, because I purchased it through a financial adviser. Consumers became weary of loads and began demanding no-load funds. So, the fund industry created Adviser Class funds in order to pay sales commissions and still claim their funds were no-load. In my opinion, the Adviser Class (aka back-end loads) can be worse than a front-end load, if you keep this fund for a long time. Instead of paying a one-time fee, you pay every year. Since loads do nothing, except reduce your return, they should be avoided at all costs.
Redemption fees are common in Adviser Class funds to ensure you keep them long enough to recapture the commission. For Example, B shares may have a 1% higher MER and a 5% redemption fee, that goes down by 1% each year. If you stay in for one year or five, they collect 5% for the commission. The C shares may have a 2% higher MER and a 3 year redemption fee. The C shares are the worst, performers over the long run.
I avoid any funds (or share classes) with a redemption fee. I think it’s a bad idea for couple of reasons. First, if you need your money for an emergency, you lose part of your investment at the worst time. Second, if the fund has bad management or it performs poorly, you have to pay to get out. Either way, it’s not in your best interest to get locked into an investment.
Some funds charge a marketing fee, also known as a 12b-1 fee. The 12b-1 is based on a rule in the Investment Company Act of 1940. These fees range from .25% to 1%, which is the maximum allowed by law. Studies have shown roughly 40% of these fees go towards sales incentives. Recently, the SEC has become critical of the 12b-1 fee and has even proposed replacing it. Their contention is that customers are unfamiliar with these fees and are often unaware they are paying them.
For me, a 12b-1 fee is a huge red flag. I generally avoid funds that have this fee, because I don’t want to pay for advertising or sales incentives (kickbacks). My experience is the best performing funds have money pouring in faster than they can invest it. They often have to close to new investors, just so they can continue their investment strategy. Only funds that perform poorly have to advertise heavily and pay incentives to find customers.
Different fund types generally have different expense ratios. For example, it takes a lot more time and research to run a Small Cap Emerging Growth fund than an Index or a Money Market fund. So, you have to take the fund type into consideration when you are comparing fees.
The table below shows the highest fee I recommend by fund type.
|Asset Class||Investment Objective||Max|
|Domestic Stock||Growth or Value||1%|
|High Yield (Junk)||.5%|
|Asset Allocation||Balanced Fund||.75%|
|Target Date (Retirement)||1%|
|Target Date (College)||1%|
The Bottom Line
The bottom line is that fees are a part of mutual fund life. But, that’s no reason to give away most of your precious returns. By avoiding commission-based advisers, marketing fees and loaded funds, you can keep most of your returns safely in your account. That is right where they belong.
“Experience is a good school, but the fees are high.”
Heinrich Heine – German Poet
Stumble Forward – Mutual Fund Basics: The Guide to Getting Started
Five Cent Nickel – Avoiding and Reducing Mutual Fund Fees and Expenses
The Biz of Life – Expense Ratios a Better Predictor of Future Performance