Key Impacts on Mutual Fund Fees
As most investors understand, running a mutual fund involves costs, such as shareholder transactions costs, investment advisory fees, and marketing and distribution expenses. Because mutual fund shareholders pay these costs through the imposition of fees, it’s important that they understand the nature of the fees they pay, as well as their sources. That’s because, all other things being equal, higher fees equate to lower returns. And even seemingly small differences in fees across funds can translate to big dollars when extrapolated over many years.
The expenses of an individual fund depend on many factors, including the fund’s investment objective, fund assets, balances in shareholder accounts and payments to intermediaries. Like the prices of most goods and services, mutual fund expenses can vary considerably. Fees on funds with different styles or that focus on different areas of the market can differ significantly, but even funds with similar investment mandates can have widely diverging fee structures. While fees alone should never drive any investment decision, investors are wise to pay attention to them. Here, then, is a primer on mutual fund fees and the key factors impacting them.
Ongoing Fund Expenses
Also known as the Operating Expense Ratio (OER), or Total Annual Fund Operation Expenses, per many fund prospectuses, a fund's expense ratio comprises various costs of managing a fund. Calculated daily, it is expressed as a percentage of the fund's average net assets.
A fund's OER includes management fees paid to a fund's investment adviser for services such as investment research and portfolio management. Some funds also incur marketing, distribution and/or service fees often paid through a 12b–1 program, named for the section in the Investment Company Act of 1940 in which they are described. Distribution fees include fees to compensate brokers and others who sell fund shares and costs relating to advertising and the printing and mailing of prospectuses and shareholder reports. Other potential fund costs include custodial expenses, legal and accounting, transfer agent services and other administrative expenses.
A fund's expense ratio will vary based on a number of factors, not the least of which is the type of assets the fund invests in. The costs involved in researching and analyzing U.S. large-cap stocks, for instance, tend to be lower because a large amount of public information about them is available. In comparison, funds that focus on U.S. small-cap stocks tend to have higher research costs because information is less readily available—meaning it takes more work to uncover. International stocks similarly incur generally higher costs for research and analysis because information on those companies and markets is often harder to come by—particularly in smaller markets such as those in developing countries.
OERs are generally lower for bond funds than for equity funds. Domestic bond funds typically incur lower costs than high-yield or international bond funds, because they generally invest in high-quality government issues and corporate securities that are widely traded. Funds that invest in high-yield bonds incur the costs relating to the fundamental research required to assess them. International bond funds tend to have higher expenses for many of the same reasons as their equity counterparts.
Management Involvement: Active vs. Passive
Passively managed funds, such as index funds, are known for their low fees. Index funds, by attempting to mirror a specific benchmark index, typically hold the same securities as the index they track, buying or selling only when the constituents of the index change, which keeps portfolio turnover low. As a result, they don't require a portfolio manager to make qualitative decisions, so their fees are generally among the lowest across all mutual funds. Investors will note, however, that many index funds underperform the index they track by some small amount; that's generally due to the fees that are imposed on the fund. (The indexes themselves do not incur such fees, but indexes cannot be invested in directly.)
Actively managed funds, on the other hand, rely on investment professionals to evaluate and make decisions on security selection and weighting, which demands applying analytical research, forecasts and their own judgment and experience. Actively managed funds also are able to react to changes in markets and developments in the investment environment, requiring additional monitoring and research. Depending on the mandate of the fund and the complexity of the environment in which it invests, active management translates to higher expenses due to the inclusion of these factors.
Management Style: Quantitative vs. Fundamental
Among actively managed funds, a key distinction relates to the type of research underlying their investment process. Quantitative funds ("quants") select securities based on calculable analysis, which typically relies on computer-based models; funds rooted in fundamental research rely on human capital to uncover value, meaning that portfolio managers must pore through financial statements as well as examine broader impacts to company success such as the competitive landscape, public policy and other risks. Quant funds tend to have lower expenses because security selection is driven by algorithms rather than the intensive, human-applied research of fundamentally driven funds.
The Good News About Fees
Anything that reduces investment returns should be a concern to investors, but the good news is that mutual fund fees are falling. Faced with mounting pressure from index funds and exchange-traded funds (ETFs), active managers are slashing their costs to remain competitive, and even passively managed mutual fund fees have been pared. Over the 10 years from 1993 through 2012, on an asset-weighted basis, the average equity-fund expenses incurred by mutual fund investors have fallen by nearly 30%, according to the Investment Company Institute, a U.S. mutual fund industry trade group.
Other fees that investors should be aware of are sales charges (loads), either on purchases (known as a front-end load) or sales (known as a deferred sales charge or back-end load), which typically go to the brokers who sell the fund's shares, and in either case reduce your investment. Redemption fees are charged by some funds when shareholders sell or redeem their shares, particularly when they do so within a short time frame. That's to dissuade investors from rapid buying and selling of fund shares, which can increase costs for all shareholders.
Fees alone should not be the sole driving factor behind investment decisions for any investor. In some cases, funds with higher costs may be appropriate—particularly when they support a unique niche or generate higher returns than alternative options. Some investors may also be willing to pay for a given adviser's level of expertise or historical performance, as well as for the flexibility that active management can offer in volatile market conditions. But investors are wise to look into and understand the fees incurred on their mutual fund investments in an effort to maximize the return that goes in their pocket.
Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges, and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing.
Investment value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost.