Mutual funds cover their expenses and make a profit by charging several different types of fees to their investors. These fees can vary considerably from one fund to another, and they are charged regardless of whether the fund is making money or not. Some fees are paid to fund managers as compensation while others are used to pay for marketing and administrative expenses. Here is a breakdown of the fees investors pay to have their money professionally managed.
The Expense Ratio
The Management Expense Ratio (MER) is the most accurate measure of a mutual fund’s total expenses. It includes both the management fee, which is the direct cost of the actual management of the fund’s investments, and the operating cost, which covers all ancillary costs of running the fund, such as marketing, overhead and other miscellaneous expenses. The actual trading costs are broken out separately in the fund prospectus.
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The MER and the management fee are often used interchangeably in financial reports and publications, although this is not correct. In fact, many fund companies don’t always clearly aggregate all of their expenses into a single ratio in the interest of concealment. However, they are required by law to publish the actual returns that the fund has historically posted net of expenses. Fund investors should be sure to review these returns when they perform their due diligence on a possible fund choice.
The Management Fee
This chunk of the expenses goes to the smallest group in the fund. The portfolio managers who make the investment decisions and steer the fund are typically paid somewhere between 0.5% and 1% of the total value of the fund each year. Of course, this obviously translates into big bucks for a manager of a fund with $700 million for example. As mentioned previously, the costs relating to placing trades are not included in the management fee. However, this fee does include some other miscellaneous expenses.
This fee is paid out of the fund assets to cover distribution costs and shareholder service expenses. They get their name from the SEC rule that permits mutual funds to pay them out. Any fund that pays these fees is required to authorize a specific plan for this. Distribution fees pertain to the costs required to market and sell the fund to investors. These include any commissions that are paid to brokers for selling the fund, the cost of printing prospectuses and other marketing materials. The SEC has no limit on how high these fees can be, but FINRA has imposed a ceiling of 0.75% on fund distribution fees.
Shareholder service fees are used to pay customer service employees or others who assist customers with questions or other issues and provide investors with fund data and other information they need to know about their fund holdings. 12b-1 plans do not always have shareholder service fees built into them. If these fees are included in the plan, they will be lumped together with the distribution fee. If they are not included, then they will be listed as an operating expense. These fees have a 0.25% limit imposed on them by FINRA regardless of whether or not they are included in the plan.
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The remaining expenses that are charged by a mutual fund include the other operational costs that are required to run the fund, such as legal fees, accounting fees, the cost of paying the transfer agent to service the fund, custodial fees and other miscellaneous administrative costs. These costs are listed on the line titled “Total Annual Operating Expenses” in the fund prospectus.
These fees are by far the largest that are charged by any mutual fund. Not all funds have them, but sale charges represent the commissions that are paid to the brokers or other salespersons who sell these funds. There are several ways these charges can be assessed. They can be paid up front, paid at redemption or both.
“A share” funds charge their fee upon purchase, while “B shares” have a contingent deferred sales charge schedule that declines each year until it disappears. Investors who purchase B shares may therefore not pay a sales charge per se if they hold the fund long enough, but they will pay higher annual management fees as a result. “C share” funds typically assess a smaller sales charge both at purchase and at redemption, unless the fund is held for a sufficient amount of time.
The amount of the sales charge that is assessed will vary according to a breakpoint schedule. For example, a fund might have an initial sales charge of 5.75% for class A shares for purchases of up to $50,000. The charge for the next $50,000 purchased is 4.75%, then drops to 3.75% for purchases of $100,000 to $250,000, and so on until the sales charge disappears, usually for a purchase of $1 million or more. However, brokers will still typically be paid a 1% commission for million dollar purchases as a courtesy from the fund (and, of course, as an incentive for the broker to make million-dollar sales of the fund shares).
A purchase of class B shares would result in a charge of perhaps 4.75% if the investor sells the shares within a year of purchase, a charge of 3.75% in the second year and so on until the schedule expires. Class C shares might charge one to two percent at purchase and then a one or two percent surrender fee if the fund is held less than two years.
The Bottom Line
Mutual funds assess a range of fees and charges to investors in return for their money management services. Some fees like the MER and 12b-1 fees are charged on an annual basis while other fees such as sales charges are only assessed at purchase or redemption.