Mutual funds have received a lot of press over the past year. Much of it has been bad. Brokers have been accused of a failure to disclose their compensation arrangements to customers. Other firms have been accused of allowing favored clients to time their investments to the detriment of small shareholders. These are among the higher profile problems with mutual funds. The more fundamental problem is the persistence of a bloated cost structure. Yet there is a wide divergence of expenses among mutual fund options - with a decided advantage going to index funds. This article will identify and explain the cost components of fund management.
Management fees are the cost that most investors have general familiarity with. This is a fee charged by a fund's investment adviser for managing the fund's portfolio of securities and providing related services.
A second component is administrative or "Other" Expenses. These expenses include, for example, fees paid to a fund's transfer agent for providing fund shareholder services, such as toll-free phone communications, computerized account services, website services, recordkeeping, printing, and mailing.
Recent survey information from the investment company institute indicates that these indirect costs amount to 1.35% annually for equity mutual funds.
An additional cost center exists for classes of mutual funds sold through broker - dealers. Funds sold through this channel have distribution charges known as 12b-1 fees deducted on an ongoing basis. Class A shares typically charge 0.25% in 12b-1 fees while class B and C shares are usually about 1.00%. 12b-1 trailers are used to compensate brokers for service provided to fund shareholders at the time of a purchase of fund shares or for administrative and advice services provided to the shareholder after the initial purchase.
While A shares have lower 12b-1 fees, they charge sales loads of between 3% and 6% to new investors. This is an explicit cost deducted from the initial investment. While it does not affect the stated performance of Class A shares, the cost is nevertheless born by the investor. Class B shares have a deferred sales load that gradually decreases to zero within 7 to 10 years. It typically starts at 5% to 7% and dissipates thereafter. Investors are sold B shares in lieu of A shares as "all their money goes to work immediately". However, B shares lock in the investor for a prolonged period during which time substantial 12b-1 charges are levied. Overall B shares are the most expensive way to invest.
Index Funds are Cheaper
Index funds, available to direct investors and fee-only advisors, offer the best value. As they do not involve active management, their management and administrative fees are much lower (usually less than 0.30% annually). As there is no sales agent to compensate, they are free of distribution fees and sales charges as well.
Over the course of a ten-year holding period, an indexed equity fund will accumulate nearly 20% more wealth than a similar fund sold through a broker. The cost advantage of index funds compounds over time. Small differences can exert a greater and greater effect as one's investment horizon expands.