There's always fine print. From cell phone coverage to satellite television service, you usually have to struggle to understand all the different costs you have to pay. Some of them are obvious: you'll pay a given amount each month, which is usually in big print in whatever advertisement convinced you to get the service in the first place. Some, however, are less obvious: fees to rent equipment, fees if you break your contract, fees if you use some optional service. If you're not careful, you may well get a big surprise with your first bill.
The same is true for mutual funds. When you make an investment in a mutual fund, no fund company will ask you to write a separate check for the fund's fees and expenses -- but that doesn't mean you're not going to pay. Funds charge a number of different types of fees, some more obvious than others. The more you pay to the fund, the less money you have left in your pocket. Here's a guide to the various fees you should be aware of when buying a mutual fund.
Sales loads, coming and going
Some mutual fund companies find most of their investors through the use of brokers, financial advisors, and other third-party salespeople. In order to compensate these outside financial professionals for the work they do for individual investors, these companies often charge a fee called a sales load. There are a few different ways a fund company can charge a sales load. One way, called a front-end sales load, involves taking a percentage of your investment when you buy shares of the fund. This percentage can be as high as 8.5% of your initial investment, and instead of going into the fund, the money is paid to the person who sold the fund to you. This means that if you make a $10,000 investment in a mutual fund, as much as $850 may go immediately to your financial advisor, leaving only $9,150 in your investment account.
Because many investors aren't comfortable with the idea of immediately losing money when they invest, some funds wait to charge this fee until the investor sells shares of the fund. In this case, the fee is called a back-end sales load. Using the same example, your entire $10,000 investment in a fund that uses a back-end load will be invested in the fund, but if you were to sell it the next day, as much as 8.5% could be withheld from your proceeds and paid to your financial advisor. Some funds that use back-end loads decrease the amount they charge if you hold the investment for a certain minimum length of time. If you sell the fund within the first year or two after purchase, you may pay a relatively high back-end load; whereas if you hold the fund for five or ten years, you may pay a smaller back-end load or no load at all. These sliding-scale charges are sometimes called contingent deferred sales charges.
It's easy to see how sales loads create a conflict of interest between you and your financial advisor. Thousands of no-load funds are available for investors, but your financial advisor won't get any compensation if you buy one. Because the money from sales loads doesn't go into the fund itself, there's no reason to believe that a sales load leads to any better performance. Furthermore, a starting loss of 8.5% means investors must earn significant income just to get back to breaking even on their initial investment. In general, paying a sales load rarely makes any sense. There's almost always another, similar fund without a load.
The 12b-1 fee is also related to sales and marketing costs. Named for the SEC rule that authorizes them, 12b-1 fees allow mutual fund companies to charge ongoing fees on an annual basis to support various expenses, including sales commissions to advisors, advertising, promotional materials, and other costs of marketing and distributing funds. These fees generally range from 0.25% to 1% each year.
Unlike sales loads, which are charged only once at the purchase or the sale of shares, 12b-1 fees are taken from your account continually. So while a 1% 12b-1 fee may seem a lot less worrisome than a sales load of 8.5%, you may well end up paying more in 12b-1 fees if you hold mutual fund shares over the long term. Furthermore, because 12b-1 fees are generally taken from the income distributions your mutual fund pays to you, you may well not even notice how much you're paying for the fee. While you can find a description of general fund fees and expenses in every fund prospectus, you won't get an itemized bill from your mutual fund explaining exactly how much money you paid for each type of fee. Because they are difficult to calculate and easily concealed, 12b-1 fees are sometimes referred to as hidden loads.
Just from these two examples of fees, you can see that a significant part of the expenses you will pay as a mutual fund shareholder have little or nothing to do with the ongoing operations of the mutual fund itself. Many financial services providers, from traditional brokers like Merrill Lynch
In addition to sales and marketing fees, mutual funds also charge fees to cover the costs of operating the fund itself. The next part of this article will discuss these operational fees in greater detail.
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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. Bank of America is a Motley Fool Income Investor pick. The Fool'sdisclosure policyis priceless.