Mutual funds are a great way for people to invest in the stock market. By allowing for instant diversification, investors without a lot of money are able to control risk and earn a higher return than if they kept their money sitting in a bank savings account.
But as much as I like mutual funds, there is a dark side to them, namely fees. Now both mutual funds and exchange-traded funds charge fees to investors. After all, you have a management team running the mutual fund and they need to get paid for doing their job.
But some mutual funds take the fees they charge too far. And in some cases, they hide these fees really well. The fees will be labeled in ways that the average person won’t understand or even won’t know that the fee is outrageously high.
So today we are going to look at mutual fund fees. By the end of this post, you will be able to take a better look at what you are investing in and understand the secret costs of mutual funds.
The Secret Costs Of Mutual Funds
#1. Management Fee
This fee isn’t so much a secret as mutual fund companies are required to clearly disclose this cost and most investors are aware of it. Unfortunately, though, most investors don’t know just how large of an impact it has on the long-term growth of their investments.
At the end of the day, the higher the management fee, the more you are paying to invest in a fund. And despite what you might have heard, there is zero correlation between a high expense ratio and better returns. The two are mutually exclusive.
To allow your money to grow the most for you over the long term, you should keep this fee as low as possible. In fact, smart investors keep this fee to under 0.50% for each fund. This can be difficult for small-cap mutual funds and international funds, but there are low-cost options out there.
This is a commonly misunderstood secret cost of mutual funds. There are load funds and no load funds. A load fund charges you a percent of your investment to invest in the fund, typically 5.75%, whereas a no-load fund doesn’t charge you anything to invest.
For example, let’s say you had $1,000 to invest. If you choose a no-load mutual fund, your entire $1,000 is getting invested into the mutual fund. But if you choose to invest in a load mutual fund with a 5.75% load, then $942.50 is getting invested and you are paying $57.50 to invest in the fund.
There is really no reason to pay to invest in mutual funds. First, you can invest in a huge quantity of no-load funds for free. Second, there is no correlation here either that load funds outperform no-load funds. And finally, load mutual funds tend to have higher management fees as well.
So when you invest in a load mutual fund, a good portion of your hard-earned money is going to fees and not investments.
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#3. Contingent Deferred Sales Load
A contingent deferred sales charge is a sneaky fee of the secret costs of mutual funds. A fund may advertise itself as a no-load fund, but they hit you with a fee when you go to sell your investment. In many cases, if you try to sell within a 5 year period after buying shares, you are hit with a 5% fee.
In some cases, the fee is a sliding scale, which lowers the fee annually each year. So if you sell in the first year the fee is 5%. Sell in the second year and the fee is 4%, and so on.
As with load mutual funds, you should avoid funds that charge this fee. But understand that some good mutual funds do charge a small fee for selling shares within a 3 or 6-month window.
What is happening here is that one sector of the economy is hot, like healthcare, and lots of investors are putting money into a specific mutual fund. To ward off short-term investors who cost the mutual fund money, the mutual fund will enact a short-term trading fee.
This isn’t an issue as long as you plan to keep your investment for the long term.
#4. 12b-1 Fee
This is a fancy term for a marketing fee. Most mutual funds include this number in their management fee, but some break it out as an added fee. The fee is typically 1% or less. Most times I see it as 0.25%.
Understand that you pay this fee every year you own the fund, just like with the management fee.
For the most part, you should try to steer clear of mutual funds that charge this fee. The really good mutual funds account for marketing expenses in the management fee and still are able to keep it low.
While this isn’t a direct fee you pay, it has an impact on the fees you do pay. Turnover is another way of saying how often the management team of a mutual fund sells out of or turns over investments.
Let’s say a mutual fund has a turnover rate of 100%. This means that at the beginning of the year, none of the stocks it owns will still be held at the end of the year. So if you are buying the mutual fund because of its exposure to Apple stock, you might want to think again because come year-end, it won’t own that stock. If you want to guarantee you will continue to own this and other Motley Fool stock picks, you’ll have to own them individually.
The higher this number, and it can be higher than 100%, the more trading the management team does. And when they trade, they incur fees which they pass along to you the shareholder. This causes the management fee you pay to increase.
At the end of the day, these are the secret costs of mutual funds. Some of these fees are required that investors pay. It is part of the process of getting a team of investment professionals to manage the mutual fund.
But this doesn’t mean you should turn a blind eye to the fees you are paying. Do your homework and pick low-cost mutual funds that don’t charge a load and don’t have a lot of additional fees. The lower the fees you pay, the more your money stays invested and can grow and compound for you over time.