Nearly every time you purchase something, you get a detailed receipt. With a receipt, you know exactly where your money is going and just how smart -- or ridiculous -- your spending decisions have been.
Not so with mutual funds. As a mutual fund investor, you'll never write a check to a mutual fund for its services. That means you'll never know exactly where your money is going unless you're very, very vigilant. Any service charges for mutual funds come right off the top of your investment, or straight out of your returns. Because costs are deducted this way, many investors aren't even aware of how much they're paying for their mutual funds.
Mutual fund fees can be broken down into two main categories: one-time fees and ongoing annual expenses. Not all funds charge one-time fees, but all funds charge ongoing annual fees of some sort. Return figures that you see for mutual funds in newspapers, annual reports and financial websites typically don't reflect one-time fees, but ongoing expenses are almost always deducted from return figures that you see in public sources.
There are three types of one-time fees that you may pay, each of which is usually charged when you buy or sell a fund. Remember, not all funds charge these fees; to find out if a fund does, consult its prospectus or its website or call the fund's toll-free number.
1. Sales commissions. Commissions are commonly called loads. If you are charged a commission when you purchase shares in the fund, that's known as a front-end load; a sales charge when you sell is a back-end load. (Some back-end loads phase out if you hold the fund for a certain number of years.)
You might also pay a level load, or a percentage of your return, each year for five years or so.
Loads come directly out of your investment, effectively reducing the amount of money that you're putting to work. For example, if you made a $10,000 investment in a fund that carried a 4.5% front-end load, only $9,550 would be invested in the fund. The remaining $450 would go to the adviser or broker who sold you the fund.
Basically, loads are payment to the adviser who sells you the investment; it's his or her compensation for giving you financial advice. So if you're buying a load fund, be sure you're getting solid investment advice in return.
Front-end charges can't be more than 8.5%, and they're generally no higher than about 6%. Back-end loads often start at about 5% or 6%, and many funds reduce them each year that you leave your money in the fund. You might find that when you buy a fund, the exit fee is 5%. If you wait four years to sell it, the fee could fall by a few percentage points. If this is the case with your fund, your broker will probably call it a contingent deferred sales fee or something like that.
2. Redemption fees. Redemption fees differ from loads in that they are usually paid directly to the fund -- in other words, they go back into the pot rather than to the broker or adviser. You may have to pay a redemption fee if you hold a fund for only a short time. In most cases, this time frame is less than 90 days, but it can be as long as a few years.
These fees are an attempt to discourage short-term traders from moving in and out of funds. The fees are put in place for the protection of the shareholders and the fund managers. Why are these short-term traders (often called market timers) bad for everyone else? Market timers may attempt to cash out of their investments all at once. A rash of sales can force fund managers to sell securities that they don't really want to sell; after all, they have to get the cash from somewhere to meet the redemption calls. And if management has to sell securities that have gained in value, it may also pass along a taxable capital-gains distribution to shareholders who remain behind. So in a sense, redemption fees are the friend of long-term investors, because they'll never have to pay them, and the fees (in theory, at least) keep timers at arm's length.
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