The Costs of Mutual Funds?

Costs are the biggest problem with mutual funds. These costs eat into your return, and they are the main reason why the majority of funds end up with poor performance. What's even more disturbing is the way the fund industry hides costs through a layer of financial complexity and jargon. Some critics of the industry say that mutual fund companies get away with the fees they charge only because the average investor does not understand what he/she is paying for.

Fees can be broken down into two categories:
1. Ongoing yearly fees to keep you invested in the fund.
2. Transaction fees paid when you buy or sell shares in a fund (loads).

The Expense Ratio:-

The ongoing expenses of a mutual fund are represented by the expense ratio. This is sometimes also referred to as the management expense ratio (MER). The expense ratio is composed of the following:

1. The cost of hiring the fund manager(s) - Also known as the management fee, this cost is between 0.5% and 1% of assets on average. While it sounds small, this fee ensures that mutual fund managers remain in the country's top echelon of earners. Fund managers are definitely not going hungry! It's true that paying managers is a necessary fee, but don't think that a high fee assures superior performance.

2. Administrative costs - These include necessities such as postage, record keeping, customer service, cappuccino machines, etc. Some funds are excellent at minimizing these costs while others (the ones with the cappuccino machines in the office) are not.

3. The last part of the ongoing fee this expense goes toward paying brokerage commissions and toward advertising and promoting the fund. That's right, if you invest in a fund, you are paying for the fund to run commercials and sell itself!

On the whole, expense ratios range from as low as 0.2% (usually for index funds) to as high as 2%. The average equity mutual fund charges around 1.3%-1.5%. You'll generally pay more for specialty or international funds, which require more expertise from managers.

In case you are still curious, here is how certain loads work:

1. Front-end loads - These are the most simple type of load: you pay the fee when you purchase the fund. If you invest 1,000 in a mutual fund with a 5% front-end load, 50 will pay for the sales charge, and 950 will be invested in the fund.

2. Back-end loads (also known as deferred sales charges) - These are a bit more complicated. In such a fund you pay a back-end load if you sell a fund within a certain time frame. A typical example is a 6% back-end load that decreases to 0% in the seventh year. The load is 6% if you sell in the first year, 5% in the second year, etc. If you don't sell the mutual fund until the seventh year, you don't have to pay the back-end load at all.

A no-load fund sells its shares without a commission or sales charge. Some in the mutual fund industry will tell you that the load is the fee that pays for the service of a broker choosing the correct fund for you. According to this argument, your returns will be higher because the professional advice put you into a better fund. There is little to no evidence that shows a correlation between load funds and superior performance. In fact, when you take the fees into account, the average load fund performs worse than a no-load fund.