Mutual funds are great for small investors looking for a smart way to save, but they aren't free. The first part of this article discussed fees that pay the people who sell mutual funds to you. In addition to these sales and marketing costs, however, the fund must also cover internal expenses. As a shareholder, the mutual fund will make you pay your share of these costs, too.
Management fees
All mutual funds hire one or more fund managers to invest the money they receive from shareholders. In some cases, the fund manager is employed by another division of the mutual fund's parent company; in others, the mutual fund hires an outside manager to make independent investment decisions.
Compensation arrangements between funds and managers vary widely. Some managers receive a fixed percentage of the total assets of the fund. However, managing a mutual fund involves both fixed and variable costs; to accurately reflect them, some fund managers agree to a sliding scale of compensation. For instance, a fund manager might agree to an annual fee of 0.50% of assets up to $100 million, then 0.30% for all assets greater than $100 million. If the fund has $200 million in assets, the fund manager will collect $500,000 in fees for the first $100 million, and $300,000 for the second $100 million, for a total of $800,000, or an average of 0.40% of total assets.
For a real-life example, observe the Fidelity Magellan Fund (FMAGX). Its latest prospectus lists a management fee of 0.39%. If you have $10,000 invested in Magellan, you will pay about $39 per year for fund management costs. Although this may seem like a small amount, keep in mind that many mutual funds have huge numbers of shareholders and substantial total assets under management. Magellan has about $45 billion in assets, so Magellan's fund manager receives a rough total of $175 million.
These management fees won't appear on your annual mutual fund statement. Instead, they are taken directly from the income that the fund distributes to you. As a result, you never see the exact amount of withheld fees; you only see the net amount of income that is distributed to you after fees are taken.
In general, you can expect to pay the lowest management fees for funds focusing on large-company U.S. stocks like Pfizer (NYSE:PFE) and Caterpillar (NYSE:CAT). More specialized funds, including those that focus on smaller U.S. companies like Landry's Restaurants (NYSE:LNY) or international stocks like Infosys (NASDAQ:INFY), often charge higher management fees.
Other fund expenses
Although fund management costs represent the most significant expense a mutual fund incurs, they must also pay many additional costs as well. Your mutual fund's annual or semiannual report will show you all of the fund's expenses; these are public documents, available to all investors. In reviewing the report, pay particular attention to the financial statement that lists operating income and expenses. This is sometimes called the statement of operations.
For example, look at the latest semiannual report for the Vanguard 500 Index Fund (VFINX). Under expenses, you will see that the fund incurred roughly $78.7 million in expenses over the first six months of 2006. Of this amount, the vast majority -- $64.1 million -- went to the fund manager. Marketing and distribution costs totaled $13.1 million. The custodian, the entity holding custody of all securities bought and sold from the fund, got paid $200,000. A bit more than $800,000 went for printing and mailing costs for shareholder reports. The trustees of the fund also received about $50,000.
Because costs fall and efficiency increases as assets under management grow, larger funds tend to have smaller overall expenses than smaller ones, at least as measured by percentage of total assets. The BirmiwalOasis Fund is a well-regarded fund with a five-star rating from Morningstar -- and, given its mere $17 million in assets, an expense ratio of 4.70%. (The total expenses of the fund nonetheless amount to only $800,000 per year.) Funds must reach a certain critical mass of incoming money to avoid having their expenses overwhelm their investment gains.
You don't always get what you pay for
Some people happily pay more for some items, because they believe that higher prices reflect higher quality. With mutual funds, this is clearly not always the case. Often, funds with the lowest costs are among the best performers, because their returns are not offset by high expenses. Although you may be justified in paying more than the bare minimum in fees and expenses if a fund manager has historically shown an ability to outperform other funds, higher fees and expenses generally drag down overall fund returns. A successful fund manager must overcome those fees and earn enough for the shareholders to feel comfortable paying the manager from their returns.
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Fool contributor Dan Caplinger learned his lesson about mutual fund fees the hard way. He doesn't own any shares of the funds or companies mentioned in this article. Pfizer is a Motley Fool Inside Value pick. The Fool'sdisclosure policyis priceless.
