Mutual funds are a wonderful invention. They've given millions of people access to capital markets with a very low minimum. Those who don't want to take the time to research and monitor dozens of individual stocks can simply hire a fund manager to do the work for them.
But for all the benefits mutual funds have, there are a few aspects of these investments that some investors don't fully understand. One of the most glaring examples is the fees that funds charge their shareholders. Before you buy any fund, you should make sure you know the various expenses you will pay.
Management fees
Of course, no fund manager is going to invest your money for free, so there is a management fee attached to any mutual fund. For actively managed funds, this fee tends to be anywhere from 0.50% to 1.00% of fund assets each year. But management fees vary widely, depending on the type of mutual fund you own. For example, fees for international stock funds are typically higher than fees for domestic stock funds. Domestic stock funds are, in turn, usually more expensive than bond funds.
And as you might expect, management fees are higher for actively managed funds than they are for index funds or exchange-traded funds. So if cost is a sticking point for you, you might want to consider some lower-cost ETFs such as Spiders
Administrative fees
Fundholders also pay for the daily costs of running the fund, including record-keeping, customer service, and ongoing maintenance. These charges are typically a much smaller part of the cost of owning a fund, but you should still be aware that investors do foot the bill for these expenses.
This administrative fee is broken out separately in a company's prospectus, so check it out and make sure your fund keeps these expenses reasonable. Something in the neighborhood of 0.25% to 0.30% should set your mind at ease.
12b-1 fees
One of the more controversial charges that mutual funds can levy is the 12b-1 fee. These fees were originally designed back in the 1980s, when the fund industry was facing consolidation. Under this rule, the SEC allowed funds to pay for marketing and distribution fees directly out of the fund's assets. The theory was that the funds would then attract new assets and lower the annual operating expenses for all investors. But despite the passage of more than 25 years and an incredible boom in the fund industry, 12b-1 fees have not gone away. In fact, there are currently more than 100 mutual funds that are closed to new investment yet still charge a 12b-1 fee.
The maddening part of the 12b-1 is that very little of this fee actually goes to advertising or marketing anymore. More often that not, these fees are used to compensate broker-dealers for selling the funds. Luckily, 12b-1 fees have been getting a lot of scrutiny lately, and it is likely that some kind of reform is forthcoming from the SEC. In the meantime, however, try to avoid funds with a 12b-1 fee if at all possible.
Putting it together
The total cost of all three of these fees is represented in the fund's net expense ratio. This number should be readily available on any fund literature, including the prospectus. An expense ratio of 1.5% means that 1.5% of the fund's total assets are being spent to keep the fund running each year. Foolish investors should not invest in any fund with an expense ratio higher than the average fund in its category. According to the Morningstar database, the average fund expense ratio is roughly 1.34%, so use this as a rough baseline.
A word on loads
Loads are especially insidious fees that are charged either when purchasing a fund (a front-end load) or when selling a fund within a certain period of years (a back-end load). There is no reason why any investor should buy a fund with a load attached to it. It is unnecessary and only serves to make your broker richer at your expense. Make sure you know whether any fund charges a load before buying; if so, just say no.
As with any major purchase, an informed consumer is the best consumer. So dig into the fees your fund charges and make sure you understand them before buying. Your portfolio will thank you.
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Fool contributor Amanda Kish lives in Rochester, N.Y., and does not own shares of any of the companies or funds mentioned herein. The Fool has a disclosure policy.
