How are mutual fund fees structured?

Investment advice is already complex enough to many, so adding a discussion on fees can make heads spin for the everyday investor. While there should be disclosures explaining your fees, you may not take the time to read through them. Even if you do, you still might be scratching your head. To read the first installment in this blog series about Advisor Fees, click here.

An advisor might pick individual stocks, but that’s time consuming and can be risky. Instead, the advisors will use a lineup of mutual funds (A fund investing in numerous stocks so the investor or advisor doesn’t have to seek them out individually.). Maybe the advisor picks a handful of funds in an attempt at further diversification.

Sounds easy, right? Maybe not easy, but efficient for the investor or advisor, as the investments inside of these mutual funds are rarely managed directly by your financial advisor. That means there is an entirely separate company overseeing the fund and managing the investments inside the fund. This other entity has been established and registered with the SEC to offer mutual funds to the investing public. Below is the typical fund company structure.

Mutual Fund Company

  • Investment Adviser: Oversees investments within the fund.
  • Administrator: Handles the “back office” activities (client mailings, financial reporting, etc.).
  • Underwriter: Sells shares of the fund.
  • Transfer Agent: Executes transactions and maintains records.
  • Custodian: Holds the fund’s assets.
  • CPA: External, independent review and certification of fund financials.

That is a lot of moving parts behind a mutual fund and it comes at a cost. These companies have to pay internal and external costs to keep the fund up and running. If they want a great investment team? That costs money. If they want better distribution of the fund to financial advisors, that’s a cost called 12b-1 fees. When you own a mutual fund, you’re paying fees that pay for the annual expenses to keep the mutual fund management company going.

The name of this annual fee is called the Expense Ratio. It’s a percentage paid based on the amount you have invested in the fund. According to the Investment Company Institute, at the end of 2016 the average expense ratio was 0.83% for active equity mutual funds and 0.58% for active bond mutual funds. These fees are pretty high compared to passive index funds, though they were about one-third more expensive in the early 2000’s.

That was a lot to digest!

Take a breath, because in the words of infomercial star Ron Popeil: “But wait, there’s more!” Again, the expense ratio just covers the annual fees of the mutual fund. There’s another cost to consider, in which commission is paid to those selling the fund. Commission has become such a dirty word, the fund instead charges what is now called a load. No-load funds are available, but investors purchase them on their own rather than going through an advisor

The idea of loads is this: commissions paid to an advisor will incentivize them to put their clients in a particular fund rather than another. One fund may pay a slightly higher fee than the others. While the client’s best interest should be prioritized, financial incentives likely influence many advisor decisions.

There are even different kinds of mutual fund loads. Front-end loads pay the commission up front. If you’re looking to put $100,000 into a fund which states there’s a 5% front-end load, your money that actually is invested will be $95,000.

If you don’t want to pay up front, there are back-end loads (aka deferred sales charges). These commissions are paid when you sell the mutual fund. In many cases, if you hold them long enough, you pay no load at all. What does this mean? A fund might have a 6% backend load that decreases by one percent each year. If you sell in the first year, you pay 6%. In year two, the charge would be 5%. This continues until there is no load left and you’d pay a 0% fee from the seventh year onward.

Separate from loads, funds can also include purchase and redemption fees. These aren’t paid to the broker, but are paid directly to the fund company for investors to buy and sell shares.

When you start adding up all the expenses associated with buying, owning, and possibly selling mutual funds, a worrisome picture develops. This picture is reflected in what is called the net return. The net return is what’s left after expenses are taken. More expenses mean lower net return, which can be extremely impactful over a long period of time. Add in the annual advisor fees and you can see that a large chunk of your hard-earned money isn’t being invested on your behalf.

For an in-depth look on this subject, download our white paper on Hidden Fees, click below to download!

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About TS Prosperity Group: We want to be your partner in creating a plan that secures and empowers your financial prosperity, while giving you the ability to care for your family today and for generations to come. Contact TS Prosperity Group today by calling 844-487-3115 to schedule your prosperity planning meeting.

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