Mutual fund expenses and fees are charges that may be incurred by investors who own mutual funds in the form of transaction costs, investment advisory fees, and marketing and distribution costs.
An advised investor knows where his money is going. For an investor in any type of mutual fund, it is important to understand the expenses of mutual funds. These expenses directly affect the returns and cannot be neglected.
Table of Contents
Mutual Fund Expenses
The expenses of mutual funds are met from the funds invested in them. The ratio of the expenses associated with the process of the mutual fund to the total assets of the fund is known as the “expense ratio.” It can range from as low as 0.25% to 2%. In some actively managed mutual funds, it may be even 3%. The expense ratio is conditional on one more ratio – “the turnover ratio”.
“The turnover rate” or the turnover ratio of a fund is the percentage of the fund’s portfolio that changes yearly. A fund that buys and sells stocks more repeatedly apparently has higher expenses and thus a higher expense ratio.
The mutual fund expenses have three elements:
The Investment Advisory Fee or The Management Fee:
This is the money that goes to pay the salaries of the fund managers and other employees of the mutual funds, who manage the fund.
Administrative Costs:
Administrative costs are the costs associated with the day-to-day movements of the mutual fund. These include stationery costs, costs of preserving customer helplines and so on.
12b-1 Distribution Fee:
The 12b-1 fee is the cost associated with the advertisement, marketing, and distribution of the active mutual fund. This fee is just an extra cost that brings no real benefit to the investor. It is advisable that an investor avoids funds with high 12b-1 fees to keep their portfolio balance.
Redemption Fee
A redemption fee is another type of expense that some mutual funds charge their shareholders when the shareholders redeem their shares. Although a redemption fee is subtracted from redemption proceeds just like a deferred sales load, it is not regarded to be a sales load. Unlike a sales load, which is used to pay brokers during a sale, a redemption fee is commonly used to defray fund costs associated with a shareholder’s redemption and is paid straight to the fund, not to a broker. The Securities & Exchange Commission (SEC) limits redemption fees to 2%.
Exchange Fee
An exchange fee is an expenditure that some mutual funds house imposes on shareholders if they exchange (transfer) to another mutual fund within the same fund group.
Account Fee
An account fee is a fee that some mutual funds houses individually impose on investors in connection with the maintenance of their accounts. For example, some funds charge an account maintenance fee on accounts whose value is less than a specific dollar amount.
Purchase Fee
A purchase fee is another type of fee that some mutual funds houses charge their shareholders when the shareholders purchase their shares. A purchase fee varies from and is not supposed to be, a front-end sales load because a purchase fee is paid to the fund houses (not to a broker) and is generally imposed to defray some of the fund’s costs associated with the purchase.
Expense ratio vs Return
It is significant for the investor to watch the expense ratio of the funds that he has invested in. The expense ratio signifies the amount of money that the fund withdraws from the fund’s assets every year to meet its expenses. The more the expenses of the fund, the lower will be the returns to the investor.
However, it is also important to keep the performance of the funds in mind too. A mutual fund may have a higher expense ratio, but a better performance can more than recompense for higher expenses. For example, a mutual fund having an expense ratio of 2% and giving 15% returns is better than a mutual fund having a 0.5% expense ratio and giving a 5% return.
Investors should note:
It is not suitable to compare returns of funds in various risk classes. Returns of various classes of mutual funds are dependent on the risks that the fund takes to achieve those returns.
An equity mutual fund always carries a greater risk than a debt mutual fund. Similarly, an index fund that invests only in fairly stable and thus less risky index stocks, cannot be compared with a mutual fund that invests in small companies whose stocks are volatile and carry greater risk.
Avoiding funds with a high mutual fund expenses ratio is a good idea for the new investor. The past performance of a mutual fund may or may not be repeated, but mutual fund expenses usually do not vary much and will definitely reduce returns in future too.