All mutual funds companies charge investors for expenses associated with operating the fund. The expense ratio or management expense ratio includes management fee as well as other costs of operating a fund, including, administration, and accounting, custodial services, taxes, legal expenses, and auditing fees.
These fees fall under the category called the annual expense ratio–the percentage of the fund’s assets that are applied towards day-to-day operations. Fund management subtracts these expenses from the fund’s assets each year.
Excessive expense ratios reduce your return
Many investors find out the hard way that mutual fund fees can extract a significant portion of their portfolio gains. Investing in the wrong fund or buying and selling shares excessively can quickly erode your nest egg over time. One of the primary concerns for any investor has to do with paying too much for mutual funds.
Several years ago, a study by Morningstar discovered that low-cost mutual funds outperform high-cost funds for all time periods and data points tested by the sponsors. In addition, the study found out those mutual funds with the highest expense ratios generated lower returns than products with the lowest expense ratios.
Furthermore, funds with the highest expense ratios were merged or liquidated at a higher rate compared to funds with lower expense ratios.
Russel Kinnel, Morningstar’s director of mutual fund research and editor of Morningstar FundInvestor recommend that investors compare expense ratios as a “primary test” for selecting funds. “They are still the most dependable predictor of performance,” said Kinnel.
According to Kinnel, investors should focus on mutual fund products that are in the cheapest or two cheapest quintiles, and you’ll be on the path to success.”
As a general rule, most investment literature and advisors recommend that investors pay no more than 1.5 percent for expenses. The average expense ratio paid on mutual funds in 2012 was 107 basis points or 1.07 percent, according to the Investment Company Institute’s report on fund expenses and fees.
Investors who use brokers and financial advisors should be especially vigilant about the funds they buy. Many financial professionals depend on commissions to make their money–commissions paid from the funds that they recommend you purchase.
This means that they do not work in your best interests but work for the fund. Don’t take this to mean that all advisors working commission are out to take advantage of you.
If you decide to use a financial advisor, seek out a fee-only advisor. You pay the person based on the amount of assets managed or per hours spent working on your account. Fee-only advisors do not earn a fee on any of their recommendations. An fee-only advisor who is also a “ fiduciary” has a legal obligation to only work in your best interests.
Sales costs (Load)
In addition to the annual expense ratio, most mutual funds assess a front- or back-end sales charge. You can choose how you pay this cost. Load funds usually offer investors a choice from three share classes A, B and C.
To avoid front-end charges, do not purchase “A” shares, but buy “B” shares instead. The company collects the sales charge on the back-end. Each year you hold the shares, the charge goes down by one percentage point. The shares automatically convert to “A” shares in 5 to 7 years. If you choose “C” shares, the fund assesses an annual sales charge.
If you want to bypass upfront sales charges, invest in no-load mutual funds—no sales fees charge to customer. You will have to pay the annual expenses. However, many funds do not offer a no-load product. Other mutual fund companies like Vanguard and T. Rowe Price specialize in no-load funds.