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Pay As
You Go
Let's begin with
the first group: fees that are accounted for in a fund’s
returns. One of the largest expenses that fund investors must
pay is the management fee. The management fee is the
compensation that the advisor receives for managing the
portfolio. A fund's management fee might have several
components, including a group fee, which is levied according
to the percentage of the fund company's overall assets that
the fund represents, and a performance fee, which will raise
or lower the management fee based on the fund's
performance.
Although
management fees often represent a big chunk of fund expenses,
they're not the only costs, and you certainly wouldn't want to
compare funds solely on the basis of their management fees.
There are also administrative fees, which pay for the
day-to-day operations of the fund, as well as the cryptic
12(b)-1 fee that some funds charge. The latter is named after
the line of legislation that made it possible. The fee is used
to pay for a fund's advertising and distribution costs. By
law, a fund's 12(b)-1 fee can be no more than 1% a year. (You
might see a fund's 12(b)-1 fee split into a distribution fee,
which is capped at 0.75%, and a service fee, which cannot
exceed 0.25%.) Together, all of these fees are included in the
expense ratio, which is the most commonly used measure of a
fund's overall expenses and a figure that is frequently used
to compare mutual fund costs. Keep in mind, however, that the
actual expense ratio might not equal the sum of these fees, as
the published management fees are the maximum that the fund
company can charge, and not necessarily what the fees
were for a fund's most recent accounting year.
One
ongoing expense that is not included in the expense ratio is
the brokerage costs incurred by a fund as it buys and sells
securities. These costs are listed separately in a fund's
annual report, sometimes as a percentage and sometimes as a
dollar amount. Some trading costs, however, are not included
in this figure. The spread between the bid and ask prices of
over-the-counter stocks, for example, can be thought of as a
trading expense, but such costs are not reported by fund
companies. The annual report also includes any interest costs,
which a fund will incur if it borrows money to buy
securities.
All of
the expenses that we have mentioned so far can be thought of
as coming out of the portfolio's raw return, skimmed off the
top, so to speak. The total return numbers that you see on
this web site already account for these costs: If a fund's
return is 20%, that's its actual return to investors. If you
had $100 invested in that fund, your investment would have
grown to $120. As the table above shows, there are other
expenses that are not already accounted for in a fund's
return. Most of these are sales related.
You Put
The Load Right On Me
Sales fees are
often referred to as loads. Traditionally, loads were the
compensation that brokers received for their advice. For
example, if your broker advised you to make a $10,000
investment into a fund that had a 4.5% sales load, he or she
would receive 4.5% of your investment, and the remaining
$9,550 dollars would be invested into the fund. In some cases,
though, loads go directly to the fund company. Many Fidelity
offerings, for example, levy a 3% sales charge that is paid to
Fidelity. Regardless of who the load goes to, it is taken out
of your investment before it is invested in the fund.
Back-end, or deferred, loads work in a similar fashion, except
they are paid when you exit from a fund. Unless otherwise
stated, most published fund returns do not account for any
sales loads. (Morningstar, however, uses load-adjusted returns
for star-rating purposes.)
Another
charge that you might encounter as a fund shareholder is a
transaction or redemption fee. These fees are different from
loads in that they are generally paid directly to the
fund--they go back into the pot--rather than to the fund
company. The idea behind them is that sudden inflows and
outflows of cash force the fund manager to make purchases or
sell securities, and imposing transaction fees fairly
distribute the costs associated with such cash flows.
Redemption fees are frequently used to discourage market
timers or other active traders from moving in and out of the
fund to the detriment of long-term shareholders. Although
investors often resent these fees as an additional charge, if
they weren't charged, the fund's net returns to shareholders
would probably be lower.
Finally,
some fund companies charge account maintenance fees, usually
for smaller accounts. If you own a Vanguard index fund, for
example, you'll be charged a $10 account maintenance fee if
your account balance is less than $10,000. On a small account,
$10 a year can be fairly large on a percentage
basis.
Putting
It All Together
So how should an
investor compare fund costs? The expense ratio is probably the
best place to start--while it doesn't include all of a fund's
expenses, it does allow for meaningful fund-to-fund
comparisons. From there, you'll want to consider any sales
fees or redemption fees that a fund charges. Finally, take a
look at brokerage costs. As a general rule, the higher a
fund's turnover, the higher its brokerage costs (and the lower
its tax efficiency).
For
example, Dreyfus
Fund and USAA Growth &
Income are both
large-cap value funds, and both have reasonable expense
ratios, 0.71% and 0.89% respectively. However, if you consider
the brokerage costs of the funds, it turns out that Dreyfus
Fund, with annual brokerage costs of 0.50% is a more expensive
option than USAA Growth & Income, which incurs only 0.09%
in brokerage
costs.
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