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Course 107
Fund Costs

Introduction

These days, every time you purchase something, you get a detailed receipt. With a receipt, you know exactly where your money is going and just how smart—or ridiculous—your spending decisions have been.

Not so with mutual funds. As a mutual fund investor, you'll never write a check to a mutual fund for its services. That means you'll never know exactly where your money is going unless you're very, very vigilant. Any service charges for mutual funds come right off the top of your investment or straight out of your returns. Because costs are deducted this way, many investors aren't even aware of how much they're paying for their mutual funds.

Mutual fund fees can be broken down into two main categories: one-time fees and ongoing annual expenses. Not all funds charge one-time fees, but all funds charge ongoing annual fees of some sort. Return figures that you see for mutual funds in newspapers, annual reports, and financial Web sites typically don't reflect one-time fees, but ongoing expenses are almost always deducted from return figures that you see in public sources.

One-Time Fees

There are three types of one-time fees that you may pay, all of which are usually charged when you buy or sell a fund. Remember, not all funds charge these fees; to find out if a particular fund does, consult its prospectus or its Web site or call the fund's toll-free number.

1. Sales Commissions. Commissions are commonly called loads. If you have to pay a sales charge, or commission, when you purchase shares in the fund, that's known as a front-end load; a sales charge when you sell is a back-end load. (Some back-end loads phase out if you hold the fund for a certain number of years.) You might also pay a level load, or a percentage of your return each year for a series of five or so years.

Loads come directly out of your investment, effectively reducing the amount of money that you're putting to work. For example, if you made a $10,000 investment in a fund that carried a 4.5% front-end load, only $9,550 would be invested in the fund. The remaining $450 would go to the advisor or broker who sold you the fund.

Basically, loads are payment to the advisor who sells you the investment; it's his or her compensation for doling out financial advice. So if you're buying a load fund, be sure you're getting solid investment advice in return.

Front-end charges can't be more than 8.5%, and they're generally no higher than about 6%. Back-end loads often start at about 5% or 6%, and many funds reduce them each year that you leave your money in the fund. You might find that when you buy a fund, the exit fee is 5%. If you wait to sell it for four years, the fee could fall by a few percentage points. If this is the case with your fund, your broker will probably call it a contingent deferred sales fee or something like that.

2. Redemption Fees. Redemption fees differ from loads in that they are usually paid directly to the fund—in other words, they go back into the pot rather than to the broker or advisor. You may have to pay a redemption fee if you hold a fund for only a short period of time. In most cases, this time frame is less than 90 days, but it can be as long as a few years.

These fees are an attempt to discourage short-term traders from moving in and out of a fund. The fees are put in place for the protection of the shareholders and the fund managers. Why are these short-term traders (often called market-timers) bad for everyone else? Market-timers may attempt to cash out of their investments all at once. A rash of sales can force fund managers to sell securities that they don't really want to sell; after all, they have to get the cash from somewhere to meet the redemption calls. And if management has to sell securities that have gained in value, it may also pass along a taxable capital-gains distribution to shareholders who remain behind. So in a sense, redemption fees are the friend of long-term investors, because they'll never have to pay them, and the fees (in theory, at least) keep timers at arm's length.

3. Account-Maintenance Fees. Some fund companies charge account-maintenance fees, but such fees are usually for smaller accounts. Some Vanguard funds, for example, charge shareholders a $10 account-maintenance fee if their account balances dip below $10,000. Shareholders pay this fee each year until their account values rise above $10,000.

Ongoing Expenses

While the fees we've discussed so far are levied by only certain types of funds, all funds annually charge—and deduct from your return—the following fees.

1. Expense Ratio. Most fund costs are bundled into the expense ratio, which is listed in a fund's prospectus and annual report as a percentage of assets. For example, if ABC Fund has assets of $200 million and charges $2 million in expenses, it will report an expense ratio of 1%.

The expense ratio has several parts. The largest element is usually the management fee, which goes to the fund family overseeing the portfolio. There are also administrative fees, which pay for things such as mailing out all those prospectuses, annual reports, and account statements. These fees are periodically deducted from the fund's overall assets. These deductions reduce the fund's portfolio value.

The 12b-1 fee can be another large component of the expense ratio; Such fees are levied by roughly half of all funds. These fees are named after an SEC rule that allows fund companies to use portfolio assets to cover a fund's distribution and advertising costs. These expenses can be as high as 1% of assets. Fees that fund families pay to no-transaction-fee networks, which we'll learn about in a later lesson, often get charged to fund shareholders via 12b-1 fees.

2. Brokerage Costs. These costs are incurred by a fund as it buys and sells securities, in much the same way you might pay brokerage fees if you were trading stocks online. These costs are not included in the expense ratio, but instead are listed separately in a fund's annual report or statement of additional information.

This figure excludes some hard-to-pin-down expenses. For example, when a fund invests in over-the-counter stocks (typically stocks traded on the Nasdaq exchange), it doesn't pay the broker a set fee. Rather, the cost of the transaction is built into the stock price. It is a trading expense that comes out of your return but fund companies don't report it separately.

3. Interest Expense. If a fund borrows money to buy securities—not a very common practice among mutual funds—it incurs interest costs. This is particularly common in mutual funds that engage in long/short strategies. Such expenses are also taken out of the shareholders' annual return.

What's Reasonable?

As you can see, mutual funds are far from a free lunch. But you can keep more of what you earn by sticking with low-cost funds. What qualifies as low cost? That depends on how long you plan to own an investment, and what type of fund you're talking about.

When it comes to bond funds, no-load offerings with the lowest possible expense ratios are best for most investors. That's because the difference between the best- and worst-performing bond fund is pretty slim; bond-fund returns differ by just small amounts, so every dollar that goes to expenses really hurts your return. Our advice: Avoid bond funds with expense ratios above 0.60%.

On the stock side, a load fund may make a perfectly fine investment, if you're a long-term investor. But load-fund investors should look for funds with fairly low annual costs, such as those sponsored by American Funds. Their total costs (including sales fees) over a period of years are actually more moderate than those of many no-load funds.

You can find plenty of good funds investing in large-company stocks that charge less than 1% per year in expenses. As with bond funds, the range of returns doesn't vary much, so lower expenses (preferably less than 0.85%) give a fund a decided edge on the competition.

With small-company and foreign-stock funds, expect to pay closer to 1.2% annually. Fund companies contend that it takes portfolio managers and their research teams more effort—and more money—to research tiny companies and foreign firms because there isn't as much readily available information about them. Not surprisingly, these funds pass a portion of their extra costs on to you, their shareholders.

At Morningstar, we put a good deal of emphasis on mutual fund costs, not only because they're often hidden, but because we think favoring lower-cost funds is an easy way to improve your long-term results. We've found that over long time periods, lower-cost funds tend to outperform higher-cost funds. And costs are the only thing about a fund that are absolutely predictable, year in and year out.

Quiz 107
There is only one correct answer to each question.

1 All fund investors pay:
a. Redemption fees.
b. Annual expenses.
c. Account-maintenance fees.
2 When do you pay a fund's load?
a. When you buy the fund.
b. When you sell the fund.
c. It depends on the load structure.
3 What does the expense ratio include?
a. 12b-1 fees.
b. Brokerage fees.
c. Interest expense.
4 Why should you favor low-cost funds?
a. Because the less money you pay in expenses the more money that goes to you.
b. Because low-cost funds tend to perform better than high-cost funds.
c. Both A and B.
5 A 1.2% expense ratio is acceptable for which type of fund?
a. A foreign-stock fund.
b. A U.S. fund investing in large companies.
c. A bond fund.
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