A mutual fund is an investment company that makes investments on behalf of individuals and institutions that share common financial goals. Mutual-fund investors select a fund with an investment objective that most closely matches their own. For example, they may want to maximize their current income, maximize the long-term growth of their capital, or they may want some combination of growth and income. Mutual funds provide investors with liquidity, diversification, professional management and flexibility. There are a multitude of funds available to today’s investor; in fact, there are more mutual funds than stocks listed on the American Stock Exchange.
While most of us would not consider buying a car or a television without first knowing the price, and probably shopping around, many individuals pay no attention to the cost of investing when they purchase shares of a mutual fund. All mutual funds charge fees, some large, some small; some funds hide the fees and some funds don’t. Mutual funds that charge a ‘load’ provide a commission to the salesmen who sell the fund, and are called load funds. No-load funds do not have a commission built into the product. Most importantly, when it comes to mutual funds, sales charges don’t pay for superior performance, they just pay for the salesman selling the fund. Consumer Report’s evaluation of mutual funds showed that whether a fund charges a load or not has no major affect on the fund’s investment performance. However, the load significantly reduces the amount of the investment that is actually put to work. And only 4 of the top 25 funds, as rated by Consumer Reports, charged loads, while 23 of the bottom 25 funds charged load of 4.75% or more.

Sales charge on mutual funds is of several varieties. Front-end funds are those funds that take sales fees right off the top. For example, if you invest $1,000 in an 8.5% front-end load fund (which is the maximum load allowable under the law), you pay $85 in commission and the balance, $915, is invested in fund shares. Some front-end funds call themselves "low-loads" and carry sales charges, which range from 2 to 4%.

Some funds forego the front-end sales charge and take their fees off the back-end instead. These are called contingent deferred sales charge funds since the back-end instead. These are called contingent deferred sales charge funds since the back-end commission is reduced the longer you invest in the fund.

For example, many of these funds levy a 5% charge if an investment is withdrawn within one year. The fee is reduced by one percentage point for each additional year the fund shares are held. Thus, the sales charge completely disappears if the investment is held for 5 years or more.

Some mutual funds levy an ongoing sales charge rather than either front- or back-end loads. These charges, called 12b (1) charges typically average about 0.5% but can range from 0.1% to 1.25% of the value of your investment annually.

Finally, some funds combine 12b(1) charges with back-end loads. In fact, most of the back-end load funds come with 12b(1) charges attached. Note that the longer you hold the shares of such funds, the lower the contingent deferred sales charges, but the total 12b(1) fees will be greater.

Regardless of whether an investor invests in a load or no-load mutual fund, all mutual fund investors must assume the annual fund management and administrative fees. Management fees are paid to the fund’s investment advisor and generally range from 0.5% to 1.0% of the fund’s average assets. Typically, the management fee percentage is reduced as the total assets. Typically, the management fee percentage is reduced as the total assets of the fund increase. In addition to management fees, fund shareholders share expenses for administrative items. Management and administrative fees for the typical equity mutual fund range from 0.3% to 5.0% and average about 1.1% of the fund’s total assets. The combined management and administrative expenses for the typical bond fund average about 0.8% of the total assets.

Finally, mutual fund investors also assume the transactions costs that occur when a portfolio manager adds or deletes securities from the fund’s portfolio. These charges average about 2% of the value of each transaction or about 4% on a round-trip trade.

The best way to estimate the cost of investment in a particular mutual fund is by examining historical cots. These can be obtained by carefully examining the fund’s prospectus, statement of additional information and most recent annual report. It may requires some digging to assess the sales charges. Front-end and back-end load funds generally provide a schedule of charges in the first few pages of the prospectus. However, some funds have been a little sneaky about reporting 12b(1) fees, putting this data in the statement of additional information.

Transaction charges are the most difficult to assess. While mutual funds report the amount of brokerage expenses, such expenses are only a small portion of total transactions costs. Since brokerage commissions and the dealer’s bid-ask spread combined average about 4%, the total transactions costs can be estimated by multiplying the fund’s average turnover ration by 4%, using the average of the fund’s turnover ratios for the past three years.

For example, suppose that a fund’s portfolio turnover ratios for the last three years were 25%, 17% and 21%. The average ratio is 21%. Multiplying this ratio by 4% gives an estimate of transactions costs (0.8%). Of course, actual transactions costs are dependent upon next year’s portfolio turnover ratio. However, since these ratios tend to be stable over time for many funds, a three-year average of historical turnover ratios generally provides an accurate estimate of next year’s ratio.

Before an investor can analyze the cost of mutual fund investing, the length of the intended holding period must be determined. Since some fees are levied only once while others are assessed each year, the total cost of investing will vary according to the holding period.

Here is a simplified case study of fund expense analysis. Suppose that you plan to invest in a fund and hold it for three years, and you have narrowed your alternatives to four funds. Your final selection will be the fund with the lowest cost. Figure 1 illustrates the total estimated expenses for the intended three-year holding period and the annual average cost for each fund. Note that 12b(1) fees, management fees and administrative expenses have been multiplied by three, the intended holding period.

Estimated holding period three years.
Clearly, it is to the advantage of the investor to invest in Fund D, which has an average annual cost of 1.80. The higher costs of Funds A, B and C may erode return on investment by a significant amount. While some funds are better managed than shareholders over and investment lifetime, it is frequently the const of investing which makes the difference between investment success and investment failure.
Dr. Robert Gordon (949) 733-0607

The material presented herein is compiled from sources believed to be reliable, but the actual cannot be guaranteed by Let’s Talk Money. Actual statement that is non-factual in nature is current opinion and is subject to change without notice. This material is not meant to replace need for professional advice from qualified financial advisor