By better understanding the different types of expenses, you could make your investments go farther
Expense ratios? Front-end loads? 12b-1 fees? To many people, these terms are unintelligible gibberish. But they shouldn't be: they reflect fees that millions of people pay on the mutual funds contained in their 401(k) plans or personal portfolios. Despite Americans owning $11.8 trillion in mutual funds, according to the Investment Company Institute, few understand the fees they pay.
A recent study by AARP found that only 30% of 401(k) plan participants knew how much in fees and expenses they were paying on their holdings. Yet 81% thought these fees were either a very important or somewhat important part of their investment decisions. Obviously, there's a disconnect here. Fortunately, mutual fund fees and expenses actually aren't that complicated. Here's what you need to know.
For starters, mutual fund fees break down into two types: those you pay directly and those you pay indirectly.
Fees You Pay Directly: Shareholder Fees
Mutual fund investors pay shareholder fees directly, usually when either buying or selling fund shares. The fees generally exist to compensate brokers or to cover costs associated with share purchase, sale, or exchange. Here are five of the most common:
- Sales Charge or Front-End Load (at purchase)
- Deferred Charge or Back-End Load (at sale)
- Purchase Fee (at purchase)
- Redemption Fee (at sale)
- Exchange Fee (at exchange)
How these fees are calculated must be determined on a case-by-case basis. But here's an example of a common way they're calculated: a 1% sales charge load would result in a $1 fee for every $100 invested, leaving the investor with $99 worth of shares. Sometimes a deferred charge load is based on the initial share purchase amount instead of the fund's value at sale. Additionally, some deferred charge load or redemption fees gradually dissipate over time or disappear entirely if an investor holds a fund for long enough.
Some mutual funds are designated "no load" funds, which means that they have neither a sales charge load nor a deferred charge load. But these funds may still have redemption or purchase fees in place. To fully understand the fees that will be charged at purchase or sale, you must read about a fund's expenses in its prospectus.
Finally, some funds might be subject to an account maintenance fee, if there's some minimum balance threshold that an investment does not satisfy. These will generally be charged annually, as long as the fund's balance is below that threshold. The fees are often relatively small, like $20 per fund.
Fees You Pay Indirectly: Annual Fund Operating Expenses
Some investors may never realize that they're paying fees on their mutual funds indirectly, but most are. Operating expenses are generally withdrawn from a fund each day based on a fee set each year. The mutual fund industry reports operating expenses that investors must pay indirectly through a fund's expense ratio.
An expense ratio reflects the sum of all of a fund's operating expenses. If a fund's expense ratio is 1%, then that means an investor with an average annual balance of $100 would pay $1 in fees over the course of a year. Another way to think of how expensive these fees are is through a fund's annual return. For example, if a fund's average value rose by 5% in a given year but its expense ratio was 1%, then its net return is approximately 4%.