Fund costs are not really complex. Here is a rundown on the various types of costs in mutual funds:

Expense ratio – all funds have ongoing expense charges to cover costs such as management fees, utilities and rent, mailing expenses, custody fees etc. These generally vary from 0.15% to over 2.00%. Ten funds had expenses of over 5% per year and one had 29%. 

Sales charges – some funds pay commissions to agents for the sale of the funds. These costs are paid directly by the investor.

No load funds – Have no sales charges, and are the benchmark against which other funds must be measured. Investors that can pick their own funds should avoid load funds.

Front end fees – The so called A Shares. Deduct a percentage from the investor before  depositing the balance into the fund. These costs may vary from 8.5% to 1% or less on very large deposits. When deposits hit certain break points, the investor pays a smaller commission as a percentage on all the invested funds. For instance, a $10,000 deposit to a fund that charged 5% would result in a $9500 net investment. But, a $100,000 investor might only pay 3%. Paying an upfront sales charge might compared to running a 100 yard race from 5 yards behind the start line.

Back end fees – The so called B Shares or Contingent Deferred Sales Charges. The fund company pays a commission to the agent, and then charges an additional annual expense to recover the commission that they paid. These additional costs are in excess of 1% per year and continue forever. This might be compared to running a 100 yard race while carrying a 200 lb anchor. Salesmen like these funds because there are no break points. Larger investors get no credit for their larger deposits. Investors should hate them because the total cost of investing is the highest. If the investor sells before a specified time, he has a contingent sales fee deducted before he gets his share back. This percentage is applied against the entire balance of the account, not just the initial deposit, and can be as high as 6%.

Level loads – The so-called C Shares. The sales department gets and the investor pays a charge of 1% per year for as long as he holds the fund. Again, larger deposits get no reduction in fees. Over time this is a very expensive way to buy funds, unless the agent is providing truly heroic service levels on an ongoing basis.

D Shares start life like C shares, but after a set time the additional charge goes away, and the fund shares convert to A Shares.

12(b)-1 Fees are additional charges that fund companies levy to pay for promotion of additional sales of shares. These charges are included in expense ratios, and it’s the total expense that is important. There is simply no benefit to the investor for paying this expense in order to induce others to invest in the fund. May be as high as 1% per year

Additional Distribution Costs – are paid by many funds to provide shelf space on the No-Transaction Fee networks of the major discount brokerages. These costs are 0.35% per year to outfits like Schwab, Fidelity, and Waterhouse. Most investors would be far better off to pay a one-time modest transaction cost than an ongoing large expense. For instance, a $100,000 account pays $350 per year forever in distribution costs when they could pay Waterhouse a one time fee transaction fee of $22.00 for a similar fund. These costs are not disclosed well in the prospectus, but account for a major expense difference between funds.

Annual Account charges – Some funds charge a $10 to $25 annual per fund charge to cover administration costs. These charges help equalize costs between large and small investors and allow funds to charge lower expense ratios. However, they fall very heavily on small investors who should evaluate the impact carefully. A $10 charge is equal to a 1% fee for a $1000 account.

Investment expenses are not trivial, and come right out of accumulation. For instance, if two similar funds had identical gross returns, but one charged shareholders 1% more in expenses, the accumulation difference over 20 years would be huge.

$10,000 at 10% net for 20 years is $67,275

$10,000 at 11% net for 20 years is $80,623

The difference is $13,384, or much more than the initial deposit.

Frank Armstrong, CFP, is the author of Investment Strategies for the 21st Century, published here, President of Managed Account Services, Inc., a fee-only Registered Investment Advisor, and Chief Investment Strategist of DirectAdvice.com.

Note: The featured writer is solely responsible for the content of this article. The opinions expressed herein are not necessarily those of MFI or BES, Inc.

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