Puzzled by Mutual Fund Fees? Here's What You Need to Know

By better understanding the different types of expenses, you could make your investments go farther

600 hand computer REUTERS Brian Snyder.jpg

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%.

So what sorts of fees are included in an expense ratio? Here are some common examples:

  • Management Fee (investment advisor expense)
  • 12b-1 Fees (marketing expense)
  • Other Expense Fees (administrative expense, legal expenses, accounting expenses, etc.)

For example, you might see a fund with an expense ratio of 0.7%, which consists of a 0.5% management fee and a 0.2% 12b-1 fee. Keep in mind that these annual expenses can add up over time, since they're assessed every year that you own the fund. This contrasts with the sales loads explained above, which are only charged once, at purchase or sale.

Why Some Funds' Fees Are Higher Than Others

How do you know if a mutual fund's fees are fair or not? Unfortunately, there's no easy way to make this determination, since all funds are different. Some might simply have lower costs, resulting in lower fees. For example, if a fund follows a major index and is not actively managed, then it will probably have a relatively low expense ratio. But if it's actively managed or has a special investment strategy, then it might have a fee on the higher end of the range.

The average expense ratio for all mutual funds in 2010 was 1.15%, according to Lipper Inc., a mutual fund research firm. But because fees vary so widely, depending on the type of fund you're considering, you might find it useful to compare the fees of similar funds. For example, if you are looking at two funds that invest in emerging market growth stocks, then comparing their fees might be a worthwhile exercise. But if you're comparing one of those funds to another that simply tracks the S&P 500 index, you'll find it difficult to make a meaningful comparison.

Other Considerations

If you're buying mutual funds through an employer 401(k) plan, then you won't escape most of the fees explained here, but you could be at an advantage as a plan participant. Since your company may have a bunch of employees investing in 401(k) plans, its combined holdings might qualify you for lower fees than an individual would pay if investing the same amount of money as you are.

But a retail investor can still qualify for lower fees, if he or she invests enough in a fund. Maria Bruno, an investment analyst in Vanguard Investment Strategy Group explains that some mutual funds have different share classes. A high enough account balance could qualify an investor for a share class that faces lower fees. So she suggests that individual investors determine whether if by investing a little more money or by consolidating assets, they could step up into a different share class and save them money on fees.

The next time that you get a mutual fund prospectus in the mail, don't just skim it as your eyes glaze over -- or worse, toss it in the trash. Check out the expenses that you're paying. You may have similar fund options that would cost you less.

Image Credit: REUTERS/Brian Snyder