Small Business Taxes & Management

Frequently Asked Questions


Mutual Funds

 

Small Business Taxes & ManagementTM--Copyright 2003, A/N Group, Inc.

 

Fund Fees, Loads, and A, B, C Shares

Mutual funds have come up with a number of ways of making money on their products. The discussion below isn't exhaustive but is representative of how you can be separated from your investment dollars.

Annual fees. These are not commissions to buy or sell a fund. Instead, it's a charge for managing the fund. It includes the cost of preparing the annual report, telephone operators answering questions, as well as stock analysts, fund managers, etc. Every fund will have an annual fee. The issue here is not the fee but how much. To determine how much you have to look at the expense ratio (annual fee divided by net assets of the fund). Some funds have an expense ratio of less than 0.2%. Index funds which require little management typically have the lowest expense ratios. But the expense ratio for the same type of index fund run by two different mutual fund companies can be significantly different. The expense ratio on a managed fund can be over 3%. That means the mutual fund company is charging 3% of the net assets per year to manage the fund. Is that excessive? It depends. If the fund charging 0.2% went up 10% when the market advanced 20% and the fund charging 3% rose 30%, paying the higher fee made sense. Unfortunately, studies have shown that the correlation between fees and performance is not good. If you're investing in an index fund, money market fund, etc., you should probably just look for the lowest fee structure. If you're putting your money in a managed fund, first look for one with the best performance, then look at the fee.

No-load funds. Load is just another name for commission. Some funds are true no-load funds. There is no charge to buy or sell shares of the fund. Vanguard Group and TIAA-CREF are the best known families of no-load funds. Some no-load funds have a low annual fee structure. However, some funds make up for being able to claim no-load status by charging high annual fees. In some cases the annual fees more than offset the commission savings.

12b-1 fee. Named for the SEC section that allows the fee, it's an annual charge assessed against the fund to cover promotion, marketing, etc. expenses. It's sometimes used to cover commissions paid to brokers who sell the fund. The fee is usually no more than 1%. The 12b-1 fee can be charged on no-load funds and on funds that have other commissions.

A shares. Mutual funds with loads have several different ways of charging the commission. Some funds use just one approach, some use several. The different approaches are known as A, B, and C shares. With A shares the load is all upfront. The load varies widely, but can be as high as 5.75%. The disadvantage is that the load reduces the funds that are earning money for you. For example, you have $10,000 to invest. If you purchase A shares with a 4% load, the amount of money working for you would be only $9,600. That's a definite drawback if you only intend to hold the fund for a short period of time. However, when compared to B and C shares (see below), paying the upfront load is generally preferred if you intend to hold for more than 5 or so years.

B shares. These shares usually have a 1% annual fee and a back-end load. That is, a commission is charged when you sell the shares. How much commission generally depends how long you've held the shares. Under a typical schedule you might pay 5% if you sell the shares within the first year, with the charge declining to 1% if you hold for 6 years. B shares generally aren't the most advantageous.

C shares. These shares carry a 1% annual fee. The are usually sold to individuals who are working with a broker. Since there's no front- or back-end load, C shares are the best choice for short-term holdings. However, since the annual fee never disappears, you're probably better off with A shares if you intend to hold for 6 years or more.

Advisor's fees. If you use an independent financial advisor and he's compensated on a per hour or percentage fee basis, rather than on a commission from the mutual fund, don't forget to take that into consideration when looking at the total fees. Hopefully, the advisor will steer you to well managed funds carrying a low fee structure.

Analysis. There's no question that fees can eat up a significant portion of your return. There are some points to consider. First, keep in mind that, as with management fees, the effect of a load depends heavily on the return. The effect of a 4% commission on a fund that's only returning 3% a year is much more than that on a fund that's showing returns of 12% annually. Unfortunately, while the market has recently rebounded sharply, most professionals believe the outlook for the next 5 years or more suggests much more muted returns than the heady days of the late 90's. That means paying attention to commissions is important. And commissions and annual fees for an index or money market fund

Second, you've got to compare returns. You can afford to pay more for a fund with a consistently good track record. And there's nothing wrong with paying management fees for an actively managed fund. On the other hand, paying hefty commissions and management fees for an index or money market fund doesn't make sense.

Third, if you're dealing with a broker, financial advisor, bank advisor, inquire carefully about fees. Brokers, etc. have been known to push funds with the highest commissions. While there may be a good reason for purchasing those funds, you should be a bit more skeptical.

Fourth, while some mutual fund companies have argued that there's a correlation between the fees and loads and the return on the fund, most studies have shown otherwise. Funds with high fees and loads frequently do no better (and sometimes worse) than those with more modest fees.

--Last update 09/23/03


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