Individuals who invest through mutual funds pay transaction costs that often are less than those associated with buying individual stocks, bonds, and cash equivalent securities. Mutual fund investors do pay certain fees and charges for the benefits of diversification, professional management, liquidity, check writing, and record keeping. Funds also pay their operating expenses out of fund assets, and this means that investors indirectly pay these costs. Shareholder fees are charged directly to investors for specific transactions, such as purchases, redemptions, or exchanges. Annual fund operating expenses are the normal operating costs of the business that are deducted from fund assets before earnings are distributed to shareholders. The fees and charges associated with investing in mutual funds are many, and they can be confusing; some can be avoided.
Load and No-Load Funds
All mutual funds are classified as either load or no-load funds. This refers to whether or not they assess a sales charge, or load, when shares are purchased. Table 15.1 shows the basic fund classes.
Load Funds Always Charge Transaction Fees Funds
that levy a sales charge for purchases are called load funds. Load funds are generally sold by stock brokerage firms, banks, and financial planners rather than marketed directly to investors by a mutual fund company. The load is the commission used to compensate brokers. This commission, also called a front-end load, typically amounts to 3 to8.5 percent of the amount invested; this reduces the amount available to purchase fund shares. For example, assume that you and a salesperson have discussed the investment potential of the Conglomerate Cat and Dog Food Mutual Fund and you decide to invest $10,000. Because this load fund charges a commission of 8.5 percent (the maximum permitted by the Securities and Exchange Commission), the salesperson receives $850 ($10,000 0.085). As a result, only $9150 of your money is actually available to purchase shares. Such a commission is much higher than stock transaction costs, which are usually 0.25 percent to 2 percent of the security’s purchase price.
The sales charge may be shown either as the stated commission or as a percentage of the amount invested. The stated commission (8.5 percent in our example) is always somewhat misleading. In contrast, the percentage of the amount invested is a more accurate figure because it is based on the actual money invested and working. A stated commission of 8.5 percent actually amounts to 9.3 percent of the amount invested: $10,000 - $9150 = $850; $850 $9150 = 9.3%. If you
Load and No-Load Funds
All mutual funds are classified as either load or no-load funds. This refers to whether or not they assess a sales charge, or load, when shares are purchased. Table 15.1 shows the basic fund classes.
Load Funds Always Charge Transaction Fees Funds
that levy a sales charge for purchases are called load funds. Load funds are generally sold by stock brokerage firms, banks, and financial planners rather than marketed directly to investors by a mutual fund company. The load is the commission used to compensate brokers. This commission, also called a front-end load, typically amounts to 3 to8.5 percent of the amount invested; this reduces the amount available to purchase fund shares. For example, assume that you and a salesperson have discussed the investment potential of the Conglomerate Cat and Dog Food Mutual Fund and you decide to invest $10,000. Because this load fund charges a commission of 8.5 percent (the maximum permitted by the Securities and Exchange Commission), the salesperson receives $850 ($10,000 0.085). As a result, only $9150 of your money is actually available to purchase shares. Such a commission is much higher than stock transaction costs, which are usually 0.25 percent to 2 percent of the security’s purchase price.
The sales charge may be shown either as the stated commission or as a percentage of the amount invested. The stated commission (8.5 percent in our example) is always somewhat misleading. In contrast, the percentage of the amount invested is a more accurate figure because it is based on the actual money invested and working. A stated commission of 8.5 percent actually amounts to 9.3 percent of the amount invested: $10,000 - $9150 = $850; $850 $9150 = 9.3%. If you
want to invest a full $10,000 in this load fund, you will need to pay out $10,930 [$10,930 - ($10,930 x 8.5%) = $10,000].Investments of $10,000 or more often receive a discount on the load (see the “Breakpoints on Load Funds” box). So-called low-load funds may carry a sales charge of perhaps 1 to 3 percent. These funds may also be sold by brokers and are sold via mail and sometimes through mutual fund retailers located in shopping centers. About half of all mutual funds levy a load.
No-Load Funds A no-load mutual fund sells shares at the net asset value without the addition of sales charges. These mutual fund companies let people purchase shares directlyfrom the mutual fund company without the services of a broker,banker, or financial planner. Interested investors simply seek out advertisements for these funds in financial newspapers, magazines, and the Internet and make contact through toll-free telephone numbers, online, or mail. The SEC does allow funds to be called “no-load” even though they assess a “service fee” of 0.25 percent or less when shares are purchased.
Some No-Load Funds Assess 12b-1 Fees A 12b-1 fee (named for the SEC rule that permits the charge) is an annual charge deducted by the fund company from a fund’s assets to compensate underwriters and brokers for fund sales as well as to payfor advertising, marketing, distribution, and promotional costs. A 12b-1 fee is also known as a distribution fee. For load funds, these charges also pay for trailing commissions, which is compensation paid to salespeople for months or years in the future.
Although the funds do not call 12b-1 fees “loads” because they are not charged up front, they have the same effect as loads that is, they reduce the investor’s return. These hidden fees decrease a shareholder’s earning power each year without being described as a sales commission. A 12b-1 fee is actually a “perpetual sales load” because it is assessed on the initial investment as well as on reinvested dividends, every year, forever. The SEC caps 12b-1 fees at 0.75 percent, although it permits a 0.25 percent “service fee,” which brings the total cap to 1 percent. Some funds stop assessing 12b-1 fees after four to eight years.
Some No-Load Funds Assess Deferred Load and Redemption
Fees Approximately 60 percent of no-load mutual funds (and many load funds) assess additional fees for transactions, such as deferred load and redemption charges. A deferred load, also known as a back-end load, is a sales commission that is imposed only when shares are sold. Deferred loads are often on a sliding scale. Thefee may decline 1 percentage point for each year the investor owns the fund. For example, a fund might charge a 6 percent fee if an investor redeems the shares within one year of purchase, and then the fee declines on an annual basis, until it reaches zero after six years. redemption charge (or exit fee) is similar to a deferred load, although often it is much lower; it is used to reduce excessive trading of fund shares. The fee is usually 1 percent of the value of the shares redeemed. It disappears after the investment has been held for six months or a year. Long-term investors should not shy away from funds with redemption fees that disappear after a year.
Disclosure of Fees in Standardized Expense Table
The SEC requires that a mutual fund’s prospectus include a standardized expense table within its first three pages that describes and illustrates in an identicalmanner the effects of all of its fees and other expenses. (See Table 15.2.) Thisdescription must estimate the hypothetical total costs that a mutual fund investor would pay on a $1000 investment that earns 5 percent annually and is withdrawn after ten years. All figures must be adjusted to reflect the effects of loads and fees. Also look for the fund’s expense ratio, the expense per dollar of assets under management. Some mutual funds are much more efficient than others, and the expense ratio could range from 0.2 percent to more than 4 percent. Expense ratios average 1.45 percent for diversified stock funds and 0.40 percent for index funds.
What’s Best: Load or No Load? Low Fee or High Fee?
No-Load Funds A no-load mutual fund sells shares at the net asset value without the addition of sales charges. These mutual fund companies let people purchase shares directlyfrom the mutual fund company without the services of a broker,banker, or financial planner. Interested investors simply seek out advertisements for these funds in financial newspapers, magazines, and the Internet and make contact through toll-free telephone numbers, online, or mail. The SEC does allow funds to be called “no-load” even though they assess a “service fee” of 0.25 percent or less when shares are purchased.
Some No-Load Funds Assess 12b-1 Fees A 12b-1 fee (named for the SEC rule that permits the charge) is an annual charge deducted by the fund company from a fund’s assets to compensate underwriters and brokers for fund sales as well as to payfor advertising, marketing, distribution, and promotional costs. A 12b-1 fee is also known as a distribution fee. For load funds, these charges also pay for trailing commissions, which is compensation paid to salespeople for months or years in the future.
Although the funds do not call 12b-1 fees “loads” because they are not charged up front, they have the same effect as loads that is, they reduce the investor’s return. These hidden fees decrease a shareholder’s earning power each year without being described as a sales commission. A 12b-1 fee is actually a “perpetual sales load” because it is assessed on the initial investment as well as on reinvested dividends, every year, forever. The SEC caps 12b-1 fees at 0.75 percent, although it permits a 0.25 percent “service fee,” which brings the total cap to 1 percent. Some funds stop assessing 12b-1 fees after four to eight years.
Some No-Load Funds Assess Deferred Load and Redemption
Fees Approximately 60 percent of no-load mutual funds (and many load funds) assess additional fees for transactions, such as deferred load and redemption charges. A deferred load, also known as a back-end load, is a sales commission that is imposed only when shares are sold. Deferred loads are often on a sliding scale. Thefee may decline 1 percentage point for each year the investor owns the fund. For example, a fund might charge a 6 percent fee if an investor redeems the shares within one year of purchase, and then the fee declines on an annual basis, until it reaches zero after six years. redemption charge (or exit fee) is similar to a deferred load, although often it is much lower; it is used to reduce excessive trading of fund shares. The fee is usually 1 percent of the value of the shares redeemed. It disappears after the investment has been held for six months or a year. Long-term investors should not shy away from funds with redemption fees that disappear after a year.
Disclosure of Fees in Standardized Expense Table
The SEC requires that a mutual fund’s prospectus include a standardized expense table within its first three pages that describes and illustrates in an identicalmanner the effects of all of its fees and other expenses. (See Table 15.2.) Thisdescription must estimate the hypothetical total costs that a mutual fund investor would pay on a $1000 investment that earns 5 percent annually and is withdrawn after ten years. All figures must be adjusted to reflect the effects of loads and fees. Also look for the fund’s expense ratio, the expense per dollar of assets under management. Some mutual funds are much more efficient than others, and the expense ratio could range from 0.2 percent to more than 4 percent. Expense ratios average 1.45 percent for diversified stock funds and 0.40 percent for index funds.
What’s Best: Load or No Load? Low Fee or High Fee?
The sales commissions charged by load funds indisputably reduce total returns as illustrated in Table 15.3. When investment results are adjusted to account for the effects of sales charges, no-load mutual funds have an initial advantage because the investor has more money at work. In general, the shorter the time period you ownthe shares, the greater the negative impact of loads on the total return for the mutual fund investor. Up-front load charges are costly to the investor in the short run (less than five years), whereas annual 12b-1 charges are very costly over the long run. If you pay 1 percent per year in 12b-1 fees for a mutual fund in which you invest for ten years, you will be giving up nearly 10 percent of your investment amount in trailing commissions. Yikes! You would be well advised to invest in a load fund rather than pay 12b-1 assessments if you plan to own the fund for more than five years. Independent research has found that over five-year periods, lower-cost funds always deliver returns better than those offered by higher-cost funds. Even a small difference in fees can seriously affect long-term returns. For example, a
$50,000 portfolio earning an 8 percent annual return would grow to $176,182 in 20 years with a 1.5 percent management fee. By comparison, over the same time span it would grow to $193,484 with a 1.0 percent fee and to $212,393 with a 0.5 percent fee. Over 30 years, the returns with these fee rates would be $330,718, $380,613, and $437,748, respectively. The negative effects of high fees on long-term returns are enormous. The investor would be wise to invest in no-load fee mutual funds that have low management fees. “If you pick your own funds, sales charges [and loads] are a total waste of money,” observes Fred W. Frailey, editor of Kiplinger’s Personal Financ gazine.
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