Mutual Fund Fees
The first thing to understand about mutual fund fees is that, whether you see the mutual fund fees or not, you pay them.
There are various classes of shares of each mutual fund available for purchase (a mutual fund may offer various classes of shares to investors -- the differences are in the mutual fund fees and expenses of each share class). Several common share classes are: Class A, Class B and Class C. Each share class requires a management and operating fee and many share classes charge a 12b-1 fee.
Mutual Fund Management Fees & Operating Fees
All share classes of mutual funds carry fees that are paid out of the fund’s assets to the fund’s investment advisors (as opposed to paying the advisor who sells the fund). In other words, investors see these fees as a reduction in their net returns versus an expense on their bank or brokerage statement.
Fees and expenses vary greatly from fund to fund and may range from less than .10% to more than 2.00%, depending on the investment style, market capitalization, fund assets, fund company and share class of the fund.
SEC Rule 12b-1 authorizes a mutual fund to pay distribution and shareholder services fees to brokers to compensate them for marketing and selling their fund shares. The Financial Industry Regulatory Authority (FINRA) limits the size of these 12b-1 fees to 1.00%. These fees are deducted directly from the fund’s assets (i.e., the investor does not see the fee on his/her bank or brokerage statements).
Mutual Fund Fees and Class A Shares
Class A shares generally have front-end sales charges (also known as a “load”). The load is paid to the advisor for buying the mutual fund on behalf of investors. The Securities and Exchange Commission (SEC) does not place restrictions on the size of the sales loads charged by a fund, but FINRA imposes a limitation of 8.5% (although, according to the SEC, most funds charge far less than this).
It’s important to realize that you are entitled to breakpoint discounts on front-end sales charges if you purchase a certain amount (or commit to investing a certain amount) of the mutual fund, or if you purchase a certain amount of various funds within the same fund family. Class A shares, like all funds, carry investment management fees that are paid to the fund company to manage the fund’s investments. Many Class A shares also carry a 12b-1 fee (a 12b-1 fee of .25% is common) that is used paid to the advisor for his/her ongoing service.
Class B Shares Also Have Mutual Fund Fees
Class B shares do not carry front-end sales charges, but carry a contingent deferred sales charge (CDSC) and a higher 12b-1 fee (a 12b-1 fee of 1% is common). The CDSC is a surrender charge imposed on shareholders should they sell their shares in the fund prior to the surrender period. The CDSC is not paid to the advisor, but is paid to the fund company to cover its various costs. These costs include an upfront commission to the advisor (often as high as 4%). Once again, investors do not see these upfront commissions paid to the advisor.
The amount of the CDSC is outlined in the fund’s prospectus and depends on how long the investor holds his/her shares. Many Class B share funds have a CDSC that is reduced to 0% in year six and in year seven converts to a Class A share (which carries no surrender charges and has lower 12b-1 fees).
For example, if you purchase $10,000 of a mutual fund Class B share, the full $10,000 is invested in the fund immediately (as opposed to a Class A share, where a sales charge is deducted from your total investment). However, if you sell these shares in the fund during the first year, you could be charged a CDSC of 5% to redeem your shares.
Class C Shares and Mutual Fund Fees
Generally, Class C shares do not have an upfront load, but charge a CDSC of 1% for one year. Class C shares generally carry a 12b-1 fee of 1% and do not convert to Class A shares (the 12b-1 fee is not reduced).
Do No-Load Shares Have Mutual Fund Fees?
No-load mutual fund shares are traditional staples of do-it-yourself investors or advisors that charge an asset-based investment fee. No-loads do not carry a sales charge and generally have lower management fees (and no 12b-1 fees).
An index, with regard to investing, is a sampling of stocks or bonds that represent a particular segment of the overall financial markets. For example, the Standard & Poor’s 500 (S&P 500), is an index representing roughly 500 of the largest US companies, such as Wal-Mart, Microsoft and Exxon Mobil.
There are three primary reasons that investors may want to use index funds for their own investment strategies. These reasons are passive management, low expenses, and broad diversification.
Mutual funds can either be actively-managed or passively-managed. The manager of an actively-managed stock mutual fund, for example, is actively buying and selling stocks with the goal of "beating the market," which is measured by a particular benchmark, such as the S&P 500. There is significant risk, however, that the active manager will make poor decisions and under-perform the S&P 500 (more than two-thirds of actively-managed funds do not outperform the indexes for periods longer than 10 years).
In contrast, the manager of an index fund, which is passively-managed, is seeking only to buy and hold securities that represent the given index for purposes of matching the performance of the index, not to beat it. In summary, the reason passive management is good for the investor is captured in the saying, "If you can't beat 'em, join 'em."
Low costs are a large advantage for index funds and the cost savings translate to higher returns for the investor. For this reason, look for the index funds with the lowest expense ratios.
An investor can capture the returns of a large segment of the market in one index fund. Index funds often invest in hundreds or even thousands of holdings; whereas actively-managed funds sometimes invest in less than 50 holdings. Generally, funds with higher amounts of holdings have lower relative market risk than those with fewer holdings; and index funds typically offer exposure to more securities than their actively-managed counterparts.
Building a portfolio of mutual funds is similar to building a house: There are many different kinds of strategies, designs, tools and building materials; but each structure shares some basic features.
To build the best portfolio of mutual funds you must go beyond the sage advice, "Don’t put all your eggs in one basket:" A structure that can stand the test of time requires a smart design, a strong foundation and a simple combination of mutual funds that work well for your needs.
Use a Core and Satellite Portfolio Design
Before building begins, you will need a basic design—a blueprint—to follow. A common and time-tested portfolio design is called Core and Satellite. This structure is just as it sounds: You begin with the "core"—a large-cap stock fund—which represents the largest portion of your portfolio, and build around the core with the "satellite" funds, which will each represent smaller portions of your portfolio.
Use Different Types of Fund Categories for the Structure
With a large-cap stock fund as your core, different types of funds—the "satellites"—will complete the structure of your mutual fund portfolio. These other funds can include mid-cap stock, small-cap stock, foreign stock, fixed income (bond), sector funds and money market funds.
Know Your Risk Tolerance
Before choosing your funds, you need to have a good idea of how much risk you can tolerate. Your risk tolerance is a measure of how much fluctuation (a.k.a. volatility—ups and downs) or market risk you can handle. For example, if you get highly anxious when your $10,000 account value falls by 10% (to $9,000) in a one-year period, your risk tolerance is relatively low—you can’t tolerate high risk investments.
Determine Your Asset Allocation
Once you determine your level of risk tolerance, you can determine your asset allocation, which is the mix of investment assets—stocks, bonds and cash—that comprises your portfolio. The proper asset allocation will reflect your level of risk tolerance, which can be described as either aggressive (high tolerance for risk), moderate (medium risk tolerance) or conservative (low risk tolerance). The higher your risk tolerance the more stocks you will have in relation to bonds and cash in your portfolio; and the lower your risk tolerance, the lower your percentage of stocks in relation to bonds and cash. See these sample portfolio designs for more guidance: Aggressive Mutual Fund Portfolio Sample, Moderate Mutual Fund Portfolio Sample and Conservative Mutual Fund Portfolio Sample.
Learn How to Choose the Best Funds
Now that you know your asset allocation, all that remains is the selection of your mutual funds. If you have a broad choice of mutual funds you begin by using a fund screener or you may simply compare performance to a benchmark. You’ll also want to consider important qualities of mutual funds, such as fund fees and expenses and manager tenure.
Tips and Cautions:
If you are a beginner, you may not have the money to meet the minimum initial investment amount, which is often more than $1,000 per mutual fund. If you are only able to meet the minimum for one fund, begin with the "core," such as a low-cost large-cap Index fund, or a balanced fund. Once you've purchased the first fund for your portfolio, you can save money on the side to purchase your next fund and continue building your portfolio one fund at a time.
The old way of asset allocation was "invest for your age," where your age is the amount of bonds in your portfolio. For example, if you are 40 years old, your asset allocation would be 40% bonds and 60% stocks. Today, people are living longer so this asset allocation strategy is not as valid as it once was.
The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
Regulation of mutual funds, compared to other pooled investment options (think: hedge funds) is extensive. Mutual funds must comply with a strict set of rules that are monitored by the Securities and Exchange Commission.
The SEC monitors the fund’s compliance with the Investment Company Act of 1940, as well as its adherence to other federal rules and regulations. Since their development, the regulation of mutual funds has provided investors with confidence in terms of the investment structure and offered a number of benefits, such as:
Transparency: The holdings of mutual funds are publicly available (with some delays in reporting), which ensures that investors are getting what they pay for.
Liquidity: Shares of mutual funds are redeemed by the fund company on the trade date, which assures daily liquidity for investors.
Audited Track Records: Funds must maintain their performance track records and have them audited for accuracy, which ensures that investors can trust the fund’s stated returns.
Safety: If a mutual fund company goes out of business, fund shareholders receive an amount of cash that equals their portion of ownership in the fund. Alternatively, the fund’s Board of Directors might elect a new investment advisor to manage the funds.
The Acts and Regulations of Mutual Funds
The rules and regulations of mutual funds are extensive. The key regulations of mutual funds are:
The Investment Company Act of 1940 -- The Act regulates mutual funds (as well as other companies). The Act focuses on disclosures and information about investment objectives, investment company structure and operations.
The Securities Act of 1933 -- The Act has the objective of requiring that investors receive certain significant information pertaining to securities being offered for sale in the public markets. The Act also prohibits fraud and misrepresentations in the sale of securities.
The Securities Act of 1934 -- The Act created the SEC and empowers the SEC with authority over the securities industry.
Researching the Rules and Regulations of Mutual Funds
The SEC website offers many useful links helping to research the regulations of mutual funds as well as other securities laws.
You have decided to add mutual funds to your well-balanced portfolio. Your next step is to sift through the myriad of choices -- where do you buy mutual funds and how much is it going to cost you?
You can always go it alone and buy mutual funds from a no-load mutual fund company (such as Vanguard or T. Rowe Price or from a discount brokerage firm (such as Schwab or Fidelity). You can even seek the help of an advisor. However, when choosing how you want to purchase a mutual fund, you would be well advised to consider several factors that will affect your investment -- factors like fees and expenses, services provided and the availability of mutual funds.
The most common questions investors seeking advice for their mutual fund portfolios ask are: “Where do I go for advice?” and “How much will I pay?” You have several choices. You can hire an advisor who works for a full-service brokerage firm, discount brokerage firm, mutual fund company, bank, Registered Investment Advisor (RIA), or insurance company.
Do Your Homework
In order to understand the cost of advice, you’ll need to do a little homework, ask questions and demand full disclosure from each advisor. It’s no secret that if you seek advice you will have to pay for the service. But another question that might provide clarity when choosing an advisor is: “What services do I receive for the fees I pay?” Is the advisor simply getting paid to make a transaction, is he/she paid to provide investment advice or is he/she offering comprehensive financial planning? The answers to these questions will help you decide if the advisor is worth the cost.
What is the Cost of an Advisor?
If you choose to hire an advisor to purchase your mutual funds, you have several options with respect to paying him/her. In most cases, the advisor will dictate how he/she is paid (depending on whether they work for a bank, brokerage firm, RIA, etc.). You can expect to either pay an up-front sales charge for each buy transaction, a back-end sales charge for each sell transaction or an annual investment management fee. Sales charges may be as high as 7% and annual investment fees may range from .75% to 1.50% on assets under management. In addition to the sales charge or annual investment fee, expenses are charged by the mutual fund company for managing the fund.
Going It Alone
If you choose to go it alone, it is still important to understand the fees and expenses you’ll be charged by the mutual fund company. No-load does not mean “free.” Management and operating expenses are always charged by the fund company and should be researched prior to investing.
In addition to the management and operating expenses, if you buy a no-load mutual fund, you may pay a transaction fee through the discount broker or mutual fund company. These fees range from $0 to $75 depending on the size of the transaction and the particular mutual fund purchased. It’s also important to note that many funds will charge a redemption fee of 2% if you sell your shares in the fund within 90 days of purchase.
If you are a do-it-yourself by nature and would like to go it alone in the mutual fund world, there is no shortage of options available to you. There are many discount brokers and mutual fund companies that offer direct investment opportunities and many are even available online.
So, you have decided to add mutual funds to your well-balanced portfolio. You have a better understanding of where to buy mutual funds and how much it will cost you. You should then start to research the individual funds with a full understanding of the fees. Your next step is to decide which funds to buy in the context of your overall portfolio.
Fund distributors use various marketing and selling tactics to attract investors. They often present half-truths as facts and create misleading opinions in the minds of the investors, which can be detrimental to the investors' interests. Let us look at some of the misconceptions of fund investing.
Myth: A balanced fund is always equally balanced in a 50:50 ratio.
Fact: Balanced funds aim to achieve a balance between equities and debt. But this can tip depending on the nature of the fund. Equity oriented balanced funds typically invest at least 65% in equities and the rest in debt, others do this in a 40:60 ratio.
Myth: A fund with a net asset value (NAV) of Rs 10 is cheaper and so, more attractive than a fund whose NAV is Rs 50.
Fact: A mutual fund's NAV represents the market value of all its investments. Any capital appreciation will depend on the price movement of its underlying securities. Say, you invest Rs 1,000 each in a new fund, A (whose NAV is Rs 10) and an old fund, B (the NAV is Rs 50). You will get 100 units of fund A and 20 units of fund B. Let's assume both schemes have invested their entire corpus in just one stock, which is quoting at Rs 100. If the stock appreciates by 10%, the NAV of the two schemes should also rise by 10%, to Rs 11 and Rs 55, respectively. In both cases, the value of your investment increases to Rs 1,100. Fund B's NAV is higher than fund A's because the former has been around longer and had bought the scrip much earlier, which itself saw some appreciation. Any subsequent rise and fall in the NAVs of both these funds will depend on how the scrip moves.
Myth: Children's mutual fund schemes are ideal to assure a child's future.
Reality: MF children schemes work like any other MF scheme, and their returns depend on the performance of the markets. Most of these schemes are long term, which means the portfolio will be heavy on equity. Shortterm schemes will be more into debt. None of these schemes assures returns. Treat these funds like any other-compare their returns, risk and performance before investing.
Myth: Funds with a large corpus can generate higher returns.
Reality: Funds with a very large corpus are prone to inefficiencies as rising assets become unmanageable after a point. Also, most fund managers are comfortable managing a mid-sized fund and an increase in the AUM can adversely affect their performance. This is because large assets force fund managers to broaden their stock universe, which sometimes results in less researched or low potential stocks in the portfolio.
Myth: Funds that regularly declare dividends are good buys.
Reality: Fund houses declare dividends when they have distributable surplus. However, there are times when a fund manager declares dividends if he does not have adequate investment opportunities. Under worse conditions, a fund manager may sell some good stocks to generate surplus for dividend distribution. The motive is to attract investors.
Myth: SIPs score over lump sum investing.
Reality: A systematic investment plan ( SIP) is the best way to invest in volatile markets. It benefits by lowering the average per unit cost. However, SIPs result in lower returns in consistently rising markets. They fail to lower the average per unit cost and thereby result in lower return as compared to lump sum investments.
Source: Economic Times