An individual investor choosing a mutual fund should consider not only the fund's stated investment policy and past performance, but also its management fees and other expenses.
Comparative data on virtually all important aspects of mutual funds are available in the annual reports prepared by Wiesenberger Investment Companies Services or in Morningstar's Mutual Fund Sourcebook, which can be found in many academic and public libraries. You should be aware of four general classes of fees.
Front-End Load A front-end load is a commission or sales charge paid when you purchase the shares. These charges, which are used primarily to pay the brokers who sell the funds, may not exceed 8.5%, but in practice they are rarely higher than 6%. Low-load funds have loads that range up to 3% of invested funds. No-load funds have no front-end sales charges. Loads effectively reduce the amount of money invested. For example, each $1,000 paid for a fund with an 8.5% load results in a sales charge of $85 and fund investment of only $915. You need cumulative returns of 9.3% of your net investment (85/915 = .093) just to break even.
Back-End Load A back-end load is a redemption, or "exit," fee incurred when you sell your shares. Typically, funds that impose back-end loads start them at 5% or 6% and reduce them by 1 percentage point for every year the funds are left invested. Thus an exit fee that starts at 6% would fall to 4% by the start of your third year. These charges are known more formally as "contingent deferred sales charges."
Operating Expenses Operating expenses are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. These expenses, usually expressed as a percentage of total assets under management, may range from 0.2% to 2%. Shareholders do not receive an explicit bill for these operating expenses; however, the expenses periodically are deducted from the assets of the fund. Shareholders pay for these expenses through the reduced value of the portfolio.
12b-1 Charges The Securities and Exchange Commission allows the managers of so-called 12b-1 funds to use fund assets to pay for distribution costs such as advertising, promotional literature including annual reports and prospectuses, and, most important, commissions paid to brokers who sell the fund to investors. These 12b-1 fees are named after the SEC rule that permits use of these plans. Funds may use 12b-1 charges instead of, or in addition to, front-end loads to generate the fees with which to pay brokers. As with operating expenses, investors are not explicitly billed for 12b-1 charges. Instead, the fees are deducted from the assets of the fund. Therefore, 12b-1 fees (if any) must be added to operating expenses to obtain the true annual expense ratio of the fund. The SEC now requires that all funds include in the prospectus a consolidated expense table that summarizes all relevant fees. The 12b-1 fees are limited to 1% of a fund's average net assets per year.1
A recent innovation in the fee structure of mutual funds is the creation of different "classes"; they represent ownership in the same portfolio of securities but impose different combinations of fees. For example, Class A shares typically are sold with front-end loads of between 4% and 5%. Class B shares impose 12b-1 charges and back-end loads. Because Class B shares pay 12b-1 fees while Class A shares do not, the reported rate of return on the B shares will be less than that of the A shares despite the fact that they represent holdings in the same portfolio. (The reported return on the shares does not reflect the impact of loads paid by the investor.) Class C shares do not impose back-end redemption fees, but they
1 The maximum 12b-1 charge for the sale of the fund is .75%. However, an additional service fee of .25% of the fund's assets also is allowed for personal service and/or maintenance of shareholder accounts.
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impose 12b-1 fees higher than those in Class B, often as high as 1% annually. Other classes and combinations of fees are also marketed by mutual fund companies. For example, Merrill Lynch has introduced Class D shares of some of its funds, which include front-end loads and 12b-1 charges of .25%.
Each investor must choose the best combination of fees. Obviously, pure no-load no-fee funds distributed directly by the mutual fund group are the cheapest alternative, and these will often make most sense for knowledgeable investors. However, many investors are willing to pay for financial advice, and the commissions paid to advisers who sell these funds are the most common form of payment. Alternatively, investors may choose to hire a fee-only financial manager who charges directly for services and does not accept commissions. These advisers can help investors select portfolios of low- or no-load funds (as well as provide other financial advice). Independent financial planners have become increasingly important distribution channels for funds in recent years.
If you do buy a fund through a broker, the choice between paying a load and paying 12b-1 fees will depend primarily on your expected time horizon. Loads are paid only once for each purchase, whereas 12b-1 fees are paid annually. Thus if you plan to hold your fund for a long time, a one-time load may be preferable to recurring 12b-1 charges.
You can identify funds with various charges by the following letters placed after the fund name in the listing of mutual funds in the financial pages: r denotes redemption or exit fees; p denotes 12b-1 fees; t denotes both redemption and 12b-1 fees. The listings do not allow you to identify funds that involve front-end loads, however; while NAV for each fund is presented, the offering price at which the fund can be purchased, which may include a load, is not.
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