3. Account-maintenance fees. Some fund companies charge account-maintenance fees, but such fees are usually for smaller accounts. Some Vanguard funds, for example, charge shareholders a $20 maintenance fee per account if balances dip below $10,000. Shareholders pay this fee each year until their account values rise above $10,000. (However it can sometimes be eliminated by either consolidating accounts or signing up for e-mail delivery of account information.)
While the fees we've discussed so far are levied by only certain types of funds, all funds annually charge -- and deduct from your return -- the following fees.
1. Expense ratio. Most fund costs are bundled into the expense ratio, which is listed in a fund's prospectus and annual report as a percentage of assets. For example, if ABC Fund has assets of $200 million and charges $2 million in expenses, it will report an expense ratio of 1%.
The expense ratio has several parts. The largest element is usually the management fee, which goes to the fund family overseeing the portfolio. There are also administrative fees, which cover things such as mailing out all those prospectuses, annual reports and account statements. These fees are periodically deducted from the fund's overall assets. These deductions reduce the fund's portfolio value.
The 12b-1 fee can be another large component of the expense ratio; roughly half of all funds levy such a fee. These fees are named after an SEC rule that allows fund companies to use portfolio assets to cover a fund's distribution and advertising costs. These expenses can be as high as 1% of assets. Fees that fund families pay to no-transaction-fee networks, which we'll learn about in a later lesson, often get charged to fund shareholders via 12b-1 fees.
2. Brokerage costs. These costs are incurred by a fund as it buys and sells securities, in much the same way you might pay brokerage fees if you were trading stocks online. These costs are not included in the expense ratio, but instead are listed separately in a fund's annual report or statement of additional information.
This figure excludes some hard-to-pin-down expenses. For example, when a fund invests in over-the-counter stocks (typically stocks traded on the Nasdaq exchange), it doesn't pay the broker a set fee. Rather, the cost of the transaction is built into the stock price. It is a trading expense that comes out of your return but is not reported separately by fund companies.
3. Interest expense. If a fund borrows money to buy securities -- not a very common practice among mutual funds -- it incurs interest costs. This is particularly common in mutual funds that engage in long/short strategies. Such expenses are also taken out of the shareholders' annual return.
What is reasonable?
As you can see, mutual funds are far from a free lunch. But you can keep more of what you earn by sticking with low-cost funds. What qualifies as low cost? That depends on how long you plan to own an investment and what type of fund you're talking about.
When it comes to bond funds, no-load offerings with the lowest possible expense ratios are best for most investors. That's because the difference between the best- and worst-performing bond fund is pretty slim; bond-fund returns differ by small amounts, so every dollar that goes to expenses really hurts your return. Our advice: Avoid bond funds with expense ratios above 0.75%.
On the stock side, a load fund may make a perfectly fine investment, if you're a long-term investor. But load-fund investors should look for funds with fairly low annual costs, such as those sponsored by American Funds. Their total costs (including sales fees) over a period of years are actually more moderate than those of many no-load funds.
You can find plenty of good funds investing in large-company stocks that charge less than 1% per year in expenses. As with bond funds, the range of returns doesn't vary much, so lower expenses give a fund a decided edge on the competition.
With small-company and foreign-stock funds, expect to pay closer to 1.5% annually. Fund companies contend that it takes portfolio managers and their research teams more effort -- and more money -- to research tiny companies and foreign firms because there isn't as much readily available information about them. Not surprisingly, these funds pass a portion of their extra costs on to you, their shareholders.
At Morningstar, we put a good deal of emphasis on mutual fund costs -- not only because they're often hidden, but because we think favoring lower-cost funds is an easy way to improve your long-term results. We've found that over time, lower-cost funds tend to outperform higher-cost funds.
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