Many people invest in mutual funds without knowing precisely what they are. Think of a mutual fund as a basket of stocks, bonds, real estate or other securities. Investors pool their money together to build a portfolio and own shares in that basket’s holdings. The fund is managed by professionals who make purchasing and trading decisions, based on research, to grow the value while keeping a portfolio diversified and balanced. Mutual funds enable small-time investors to have a bigger stake in the market than they could otherwise.
Perhaps what's harder to understand are the fees associated with mutual funds. Some charge sales commissions, or loads; others don't. Some have hidden fees.
So when should investors accept fees as a means to enhance performance, and when should they walk away from their current situation and seek out less expensive mutual fund companies or products? Keep in mind that big fees siphon money from your return and consequently lower your retirement savings.
Keep reading: How Do I Reach My Retirement Goals?
What You Need To Know About Mutual Fund Fees
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1. First Thing to Consider
Costs are perhaps the biggest problem with mutual funds. The expense ratio, or the annual percentage a company charges to manage the fund, includes administrative costs such as record-keeping, marketing, taxes, legal expenses and more. A 1 percent expense ratio means the fund keeps $1 for every $100 you invested each year. In some funds, additional broker fees can drive up costs by as much as 1.5 percent, said Jeremy Shipp, a financial advisor and managing partner at O’Dell, Winkfield, Roseman & Shipp, a retirement planning firm in Denver.
2. Average Mutual Fund Fees
Generally, mutual fund fees range from 1 percent to 1.5 percent of invested assets, though some specialty or international funds requiring more fund management expertise tend to carry higher charges. To see the impact of fees to your bottom line, consider this example from the Securities and Exchange Commission: If you invested $10,000 in a fund that produced a 10 percent annual return and charged 1.5 percent in fees, then after 20 years you would have about $49,725. If the fund fees were only 0.5 percent, then you would end up with about $11,000 more, or $60,858.
3. Load or No Load
Some funds charge investors a front-end load, or a fee, which is used to compensate the broker or salesperson for selling the mutual fund. A back-end load is a fee that's charged if an investor sells the fund within a certain (usually shorter) time frame. Those costs should be disclosed in the prospectus.
Many financial planners recommend buying no-load funds to lower mutual fund costs and raise returns. Some investors believe that load funds outperform no-load funds. They would be wrong.
Christine Benz, director of personal finance at Morningstar, said that when researchers looked at factors that were most important for fund performance, "one thing we come back to is that low-cost funds tend to outperform. It’s the single data point that is predictable," she told USNews.com.
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The SEC has also echoed that sentiment on its website. Do understand, however, that no load doesn't mean free of charge. Investors are paying a fee for fund management.
4. Active Versus Passive Fund Managers
Scot Hanson, a certified financial planner in Shoreview, Minn., said mutual fund fees tend to cost more when they have an active manager. It's no guarantee that an actively managed fund will beat the passive approach that is typical of indexed funds. An index fund is a type of mutual fund constructed to match or track the components of an index such as the Standard & Poor 500. It generally has low operating expenses and low portfolio turnover.
According to a recent Forbes article, active managers generated superior returns for their clients during certain market cycles such as the market declines of 2001-2002 and 2008-2009. At most other times, they did not.
5. Funds With Lower Cost and Risk
Hanson said American Funds, a family of 33 mutual funds managed by Capital Research & Management Co., was an example of a low-fee mutual fund with an expense ratio of .75 percent. He also cited Vanguard's low .17 percent fee for managing its 500 Index Fund.
When it comes to index versus mutual funds, Hanson preferred the latter.
“An index fund is generally a fairly high-risk level fund," he said. "Many people to do not realize the added risk they are really taking. This is why I like mutual funds with lower beta (beta is the calculation of a stock's risk factor) like balanced funds, income funds, convertibles and commodities. Sometimes lower-beta funds sacrifice performance but it is well worth it."
Look for a managed mutual fund with a beta lower than 1.0, he said.
6. Hidden Fees
Excessive brokerage trading and transaction fees can cost investors big time. Those fees are not displayed as specific costs in the expense ratio breakdown or in a fund's management fees, said Keith Newcomb, a certified financial planner and portfolio manager with Full Life Financial LLC In Nashville, Tenn.
“Where you look for (these costs) is in a document called the statement of additional information, where they will be stated as brokerage or commission costs,” he said. "These will vary depending on the strategy used by the fund. Those with higher turnover or less liquid assets or foreign assets will tend to have higher trading and transaction expenses."
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He added that investment managers vary in their skill level and that investors "ought to be focusing on net performance" because "the lowest expenses won’t necessarily give you the best result.”
Still, investors can avoid these fees by doing research on a fund's performance and costs.
7. Which Fees are Avoidable?
In the pile of mutual fund fees, Hanson said that only one might be easy to avoid: annual account fees. Just to keep your account at one of the big-name fund companies or at an advisory firm like his, you might pay $250 to $500 or more a year, he said. But he added that some advisors, himself included, charge 1% percent to manage a client's money and no annual fee.
This article originally appeared on GOBankingRates.com: Mutual Fund Fees: 7 Things to Consider