Mutual funds can be great investing options for people who want the high-growth potential of the stock market, but don't want to choose individual stocks to buy. However, the convenience of mutual funds isn't free -- there are several types of expenses investors may need to pay, and these fees can really eat away at your long-term performance.
The three main types of mutual fund expenses
When you invest in a mutual fund, there are three main expenses you may have to pay. Not all mutual funds have all three expenses, and you can find the details in a fund's prospectus.
A front-end sales charge, also called a sales load, refers to money you pay upfront when you invest in a mutual fund. This is a form of commission paid to financial planners, brokers, or investment advisors. If you limit your search to "no load" funds, you can avoid this expense altogether.
A back-end sales charge, or back-end load, refers to money you pay when you sell, or redeem, your shares of a mutual fund. This expense can be a flat fee, or can gradually decrease over time to incentivize investors to hold their investments. Like front-end sales charges, these are commissions paid to third parties, and are not a part of the fund's operating expenses.
An expense ratio is the fund's annual operating expenses, expressed as a percentage of assets. Unlike the sales charges, this cost applies to all mutual funds. This covers management fees as well as other expenses of running the mutual fund. For example, a 1% expense ratio means that for every $1,000 you have invested, you'll pay $10 in expenses per year.
You may see two expense ratios listed – gross and net. A fund's gross expense ratio refers to the total annual operating expenses, while the net expense ratio may be reflective of a temporary discount, and may therefore be lower. Simply put, the net expense ratio is what the fund's investors are paying now, while the gross expense ratio is what the fund's expenses could be in the future. As a long-term investor, it's a good idea to base your decisions off of the gross expense ratio – in other words, don't assume that the lower net expense ratio will last forever.
You might be surprised at how much these expenses can really cost
As an example, let's say that you have $10,000 to invest. The S&P 500 has historically averaged returns of about 9.5% per year, and $10,000 compounded at this rate for 30 years is $152,200.
Now, let's say that you invest in a mutual fund that does just as well as the overall market. That is, the fund's investments generate total returns of 9.5% per year on average. However, to invest in this particular fund, you'll need to pay a 3% front-end sales charge, as well as a 1% expense ratio on an ongoing basis.
These may sound like small percentages, but these small fees result in a 30-year investment value of $109,200. In other words, the front-end sales charge and expense ratio reduced your investment gains by $43,000.
With that in mind, here's a calculator to use while you're shopping around for mutual funds that can help you understand the long-term impact of the fees.
The Foolish bottom line
To be clear, fees aren't the only thing you should look at when evaluating mutual funds, and funds with lower fees aren't necessarily better than funds that charge a little more.
Specifically, if the fund's performance justifies the cost, it can make perfect sense to pay the fee. For example, one of my personal favorite funds, the Dodge & Cox Stock Fund (NASDAQMUTFUND:DODGX) charges a 0.52% expense ratio while another favorite, the Vanguard S&P 500 Index Fund (NASDAQMUTFUND:VFINX) charges just 0.14%. However, the Dodge & Cox fund has consistently beaten the market, even after fees, throughout the past 50+ years, so this would be a case where the fee was well-justified.
However, this isn't often the case. Before you invest in any mutual fund, be sure the fees you're agreeing to pay are well-justified. If they aren't, you're probably better off looking elsewhere.