Understanding mutual fund fees.
Mutual fund fees can be confusing to retail investors because of the different terms to explain how the investment is packaged and managed. Retail investors researching mutual funds can compare mutual fund fees, expenses and other information on financial news sites, experts say. "It's where most professionals start their research," says Craig Bolanos, CEO of Wealth Management Group. Knowing what a mutual fund charges compared to it its peers can help investors if a higher-priced fund is worth buying. Here are eight facts to know about mutual fund fees and expenses.
Know the basics.
Mutual fund fees come in a few different flavors and have different terms that mean the same thing, says Crystal Wipperfurth, a certified financial planner at Bronfman Rothschild. The term load is the fund's sales charge, which is the commission investors pay to the mutual fund company, usually expressed as a percentage of the amount bought or sold. Upfront load fees are paid in the beginning, back-load fees are paid when an investor sells. No-load funds mean no commissions are paid. Another fee is the expense ratio, it can comprise the management fee, which is how the managers get paid. The expense ratio may also contain a "12b-1 fee" – the cost to market the fund. But not all funds have those fees.
Focus on the two main share classes.
Looking at the different mutual fund classes can feel like looking at alphabet soup. For instance, there are A-class shares or B-class shares, to name a couple. There are also institutional and investor shares, all with different trading symbols. Wipperfurth says retail investors should focus on A-class shares and C-class shares. A shares have a one-time, upfront load, which includes the financial advisor commission. It can be as high as 5.75%, which translates to $575 for every $10,000 invested. C-class shares do not have an upfront sales charge but can have a back-end sales charge if it is sold within the first 12 months. Both A- and C-class shares may have a yearly expense ratio but the A shares tend to have lower expense ratios.
Determining which share class is better.
Investors may choose C-class shares automatically to avoid the A shares' upfront loads but they should think twice about the purpose of buying a particular fund. Investors should consider how long they intend to hold the fund when deciding which share class ultimately will be less costly. "The longer the holding period, the more appropriate the class A share might be simply because it has lower on-going expenses even though it's got the drag of the upfront commission," Bolanos says. Investors who plan to only hold the fund for a short time may want to opt for C-class shares. The Financial Industry Regulatory Authority, known as FINRA, has a calculator that can help determine how long it would take to hold a fund to make an A-share fund more cost-effective, he says. Generally, A shares can be more cost-efficient for investors who plan to hold it more than three years, Bolanos says.
Fees affect performance.
Although mutual fund fees have different structures depending on the share class, the bottom line is that's the cost to compensate the financial professional, says Aaron Benson, portfolio manager at Baird Private Wealth Management. That cost affects performance and affects what an investor received. In upfront commissions, the fee is subtracted before the money is invested. Yearly expense ratios are taken out of the fund's assets. "That's all reflected in the fund's performance," he says. Investors buying A shares should be aware of breakpoints as larger investments can mean a lower upfront sales load, he says.
Mutual fund fees are falling.
Ben Johnson, director of global exchange-traded fund research at Morningstar, says mutual fund fees as a whole are down from years past as cheaper index funds are taking a bigger chunk of investors' portfolios. Johnson's April 2019 research paper shows that the asset-weighted average expense ratio for active and passively managed mutual funds and ETFs combined was 0.48% in 2018 – that's significantly cheaper compared to 0.93% in 2000. This ratio has fallen every year since 2000, he says. The growth in target-date series funds and the default choices of index mutual funds in most 401(k) plans is one example of how index mutual funds are becoming more popular, he says.
Active mutual funds charge more.
The asset-weighted average fee for actively managed mutual funds in 2018 was 0.67% compared to 0.71% in 2017, while the average fee for the passively managed mutual funds was 0.15% in 2018 – down from 0.16% in 2017. Johnson says active mutual funds charge higher fees because it's related to the cost of creating the portfolio and delivering the strategy to the client. "Index portfolios have a meaningful advantage over actively managed portfolios in that respect because the index methodology can be boiled down to an Excel spreadsheet or a Word document," he says.
Higher fees occur in more complex strategies and sectors.
Johnson's research shows the average fund cost for an actively managed U.S. equity fund in 2018 was 0.7%. Those costs rose to 0.82% on average for an international-equity fund and as high as 1.35% for an alternative strategy active mutual fund. He says there are a few reasons for the differences in costs. Part of it is the cost of creating the strategy as the cost to build and maintain a portfolio of foreign stocks, for example, can cost more, especially as an active manager tries to hew closely to the benchmark. But other times, "the case for higher fees might not hold water," he says.
More to investing than just fees.
Bolanos says controlling costs and fees are important, "but it doesn't mean we should be just investing in things that cost zero." He says investors should look that what the investment represents and what it offers. Actively traded mutual funds that invest in niche areas like biotechnology or artificial intelligence may take more research time and will have a higher cost. "Where else can someone can exposure to those sectors," he says. "You can't unless someone creates it. If that's the only way to get access, it is what it is. But we owe it to ourselves to make sure there's a process and the selections are fair."
Facts to know about mutual fund fees:
Know the basics.Focus on the two main share classes.Determine which share class is better.Fees affect performance.Mutual fund fees are falling.Active mutual funds charge more.Higher fees occur in more complex strategies and sectors.There's more to investing than just fees.