2.6: Fees, Expenses, and Share Classes, Oh, My!
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Most mutual fund investors know that they are paying for the services of the mutual fund. However, typically their understanding of how they are being charged is vague at best. My apologies on behalf of our industry because as you will see, we have done our best to make sure that the vast majority of mutual fund investors do not fully understand the costs associated with mutual fund investing. And for the most part, the industry has succeeded. As Rising Investment Gurus, it is your duty to understand thoroughly the fees and expenses of mutual funds. Study this section over and over. Your friends and family and colleagues are depending upon you.
Annual Operating Expenses
Every mutual fund has annual operating expenses. These expenses are reported as a percentage of the assets under management. Understanding the percentage of assets under management is only the first hurdle for most potential mutual fund investors with regard to expenses. There is much more to understand and internalize about mutual fund fees. Sadly, understanding the costs resulting from the percentage expense of assets under management is also often the last hurdle for puzzled would-be investors. Subsequent explanations of fees and expenses often elicit only glassy-eyed stares. Our intrepid future mutual fund investor then decides quickly to banish from their mind any further thought of the costs of mutual fund investing and to concentrate on the other juicier aspects of mutual funds such as the investment returns touted in the slick marketing material their representative sent them.
This dynamic is unfortunate because understanding the costs as a percentage of assets under management is not difficult once it is explained adequately. For example, if the annual operating expenses are 1% of assets under management, then for every $100 in the account, the mutual fund will charge 1% of $100 or $1 each year to operate the mutual fund. If the assets under management were $1,000, 1% would be $10 yearly. $100,000 would mean an expense of $1,000, and so on. It is typical to see annual operating expenses range from 0.05% or less to up to 2% and sometimes even more. Although the difference between, for example, 0.5% and 2% might seem small at first, the difference in absolute expenses can be substantial, especially when the investment amount becomes considerable.
Mutual funds have up to four annual operating expenses. Normally, the most costly annual operating expense is the management fee. This fee goes to the professional money managers who are identifying, choosing, and monitoring the securities that populate the mutual fund. Management fees range from 0.2% up to 2% yearly. Proper securities research is not inexpensive. If the money managers are doing the serious work necessary to actively manage the underlying choices in the mutual fund, the costs will be significant. As we have discussed, the world is a very small place economically and money managers must have a global outlook. Doing research across the globe is costly and the management fee reflects this cost. However, we shall see an important exception to this rule as we progress through our discussion of fees.
A second annual operating expense is the 12b-1 fee. Where did this comically baffling name come from? The 12b-1 fee’s name comes from Rule 12b-1 of the Investment Company Act of 1940. This annual fee is used to defray advertising, servicing, and distribution costs of the fund. Mutual fund companies are required to report what they pay for these costs. Are banks or life insurers, or beverage companies or car companies, for that matter, required to tell the general public what they pay for advertising? No, but according to the Investment Company Act of 1940, mutual funds companies must. Over the past two decades, 12-b fees have gotten a bad reputation because of some abuses which will be discussed soon. The 12-b fees are usually 0.25% but can be as high as 1.0%.
The third category of annual operating expenses consists of the accounting and other expenses. This is a broad category that consists of all the other expenses of operating a mutual fund such as the rent, utilities, communications, and, very importantly, the accounting. This expense ratio is usually less than 0.2%.
A last category of mutual fund annual operating expenses usually only applies to accounts that the IRS has deemed tax-advantaged accounts, also known as tax-qualified accounts. Examples of these are retirement accounts such as Traditional and Roth IRAs, health savings accounts, and educational accounts. With these accounts, the IRS requires the funds to be held by a separate trustee. Unlike the first three expenses, instead of a percentage of assets under management, the trustee typically charges a set fee of between $10 and $35 per year per account. Also, unlike the previous three fees which are paid automatically from the proceeds of the account, this fee can be paid separately outside the account by the investor. In practice, very few investors bother to write a check each year for $10 and send it to the mutual fund trustee.
Disclaimer: Because of the intense competition in the mutual fund industry, there are now a few funds that do not charge any annual operating expenses. Fidelity Investments was the first to offer a few of their funds with no annual operating expense. In marketing, this is often referred to as a loss leader. Fidelity is courting new customers with a few free mutual funds and anticipating that once they are loyal clients, Fidelity will be able to sell them other for-pay services. Obviously, no company can exist indefinitely without revenue so we will see if this marketing gambit is successful over the long term for Fidelity. If it is, we can expect other companies to follow Fidelity’s lead.
According to the Investment Company Act of 1940, all the previous fees and expenses, along with much other information about the mutual fund, must be reported in the funds’ prospectus. No doubt you have heard or seen in advertisements about mutual funds and other types of investments, “Be sure to read this and other important information about the investment in the prospectus.” Ha, ha, ha, ha, ha! This is one of our industry’s little jokes. No one reads the prospectus. Before the revolution in digital communication, every investor was required to have been given or sent to them the prospectus in writing. Now, as with other online services, you simply, “Click or tap here to acknowledge that you have read the prospectus.”
As Rising Investment Gurus, it is important for you to at least slog through one or two prospectuses. (No, the plural of prospectus is sadly not prospecti.) There are various links on the class website for you to follow. The truth is the prospectus can be very useful. If you ever suffer from insomnia, simply start reading a mutual fund prospectus. Your insomnia will be a distant memory. When Your Humble Author was first introduced to mutual funds, the representative gave me the required prospectus in writing along with the marketing material. Although I skimmed quickly through some of the material, I read every page. When I saw her again to discuss the potential investments, I asked for the prospectus of the second mutual fund that she was also thinking of recommending. She looked at me oddly and said, “You read the prospectus?” I replied that I had and was eager to read the other one. She was dumbfounded. This was a woman who had over 20 years of experience in the industry at the time and she replied, “I don’t know anyone who has read a prospectus. I’ve never read a prospectus!” At the time, I thought that this was odd since if you are going to trust your money with this company, shouldn’t you know everything you can about them? Since then, I believe that only one of my clients has ever actually read the prospectus. Also in recent years, the Securities and Exchange Commission has allowed the mutual fund companies to issue a summary prospectus which is about ¼ of the size of the full prospectuses. It is still written in such a way to put the average person asleep within one or two pages.
Before the advent of pervasive digital communications, there was a saying in the industry. “The more important the information, the cheaper the paper. The less important the information, the more expensive the paper.” This was a comment on the fact that the prospectuses were printed on drab, inexpensive paper. On the other hand, the slick marketing materials were always printed on luxurious paper in full color.
One operating expense that is often overlooked is the cost related to trading. The trading costs are not required to be reported in the prospectus. So how does one know how much the mutual fund is paying in trading costs. A quick guide is to look at the mutual fund’s turnover ratio. This is a measure of how much of the portfolio “turns over” in one year. If the turnover ratio is 100%, the mutual fund will have bought and sold the entire portfolio in one year. If it is 50%, it will take two years to turn over the portfolio. The higher the turnover ratio, the more trading costs the mutual fund will incur.
What is an optimal turnover ratio for a mutual fund? The answer depends as some mutual funds will have a high turnover ratio simply by the nature of the underlying investments. Examples of this type of mutual fund are money market mutual funds that hold short-term securities that mature in three, six, or nine months. Therefore, it is typical to see 300% or more turnover in money market mutual funds. However, with stock mutual funds, a high turnover ratio implies that the mutual fund managers are acting more along the lines of speculators and traders instead of investors. We will see when we discuss stock valuations that a turnover ratio of 20% to 30% for stock mutual funds is a respectable turnover ratio. The mutual fund managers are holding onto their stocks for an average of 3 to 5 years. A turnover ratio of 200% or more for a stock mutual fund means the managers are only holding onto their stocks for an average of six months or less. A stock turnover over 200% is not long-term investing; it is short-term speculating/trading, better known as gambling.
Load Funds versus No-load Funds
Along with the annual operating expenses, some mutual funds have a commission. The commission goes by various names including the sales commission, the sales charge and, historically, the sales load. Hence, mutual funds that come with a commission are called load funds. Mutual funds that do not have sales commissions are called no-load funds. During the first few decades of the mutual fund industry, mutual funds were sold by financial representatives such as stockbrokers and came with a sales load. The commission was used to compensate the financial representative along with the fund distributor. Eventually, enterprising new mutual fund companies began to offer no-load mutual funds without commissions that bypassed the financial representatives. The investor would deal directly with the mutual fund company via 800 toll-free phone numbers and then eventually, the Internet and other digital communications. The incessant drumbeat from the financial media will tell you that you should never buy a load fund and should only purchase no-load funds. There are two problems with this. First, along with the sales load, you need to compare the annual operating expenses. Over the long term, a no-load fund with higher annual operating expenses may wind up costing you far more than a load fund with lower annual operating expenses. Secondly, if an investor believes that they need the services of a financial representative, they should be expected to pay for these services. We will see that traditional load fund sales commission can wind up costing orders of magnitude less than the current system that has evolved to replace the traditional sales load.
In addition, as you nose about the financial media, you will invariably see something along these lines, “If you invest $100,000 into a mutual fund with a 5% sales load, at the time you invest, $5,000 will be taken out of your account and used to pay the broker and other distributors that helped get you to choose that investment. If your mutual fund grew by 8% compounded for 50 years, a $5,000 sales load charge would result in you having $234,508 less in wealth.” The problem with this assertion is that the writers are assuming that the load fund and the no-load fund will have the exact same investment returns. This would almost always never be the case. No two funds are exactly the same. The other problem with this example is that a mutual fund with a 5% sales load typically has reduced commissions for amounts over $25,000 or $50,000. We will look at so-called sales charge breakpoints below.
How did the investment services industry respond to the challenge of charging clients for their services in the face of no-load funds? The industry introduced various mutual fund share classes. As we work through the next discussions of the various types of share classes, their non-descriptive names, their sales loads and other fees and expenses, we will see yet another reason why mutual fund investors would rather not concentrate on how they are being charged. Again, it is up to you, Dear Rising Investment Gurus, to study these share classes thoroughly and internalize them so that you will be able to help your friends, family, and colleagues make sense of the fees they are paying for their funds.
Share Classes ‒ Alphabet Soup, Anyone?
The first mutual funds had a front-end sales load. The sales commission was subtracted from the purchases of the mutual fund shares. These mutual funds shares are typically now referred to as Class A shares. They would traditionally have the lowest annual operating expenses of load funds. Also, as mentioned, the sales load is typically reduced as the contributions or the amount of the investment reaches certain sales charge breakpoints. For example, the maximum sales load on a mutual fund’s A shares may be 5%. However, once the contribution or the amount in the account reaches $25,000, the sales load would be reduced to 4.5%. At $50,000, it might be reduced to 4%, and so on. Typically, once the contributions or the amount in the account reaches $1,000,000, the sales load is waived entirely. (Does this give you an idea of how much the industry simply adores high net worth individuals, often called sophisticated investors or accredited investors?) As no-load funds became more popular, many in the general public soured on the idea of sales commissions. If nothing else, the investment services industry is very good at marketing. For those individuals who did not want to pay a front-end Class A sales load, the industry created Class B shares. Class B shares have a back-end sales load. The investor paid a commission when they sold the shares. Savvy investors would respond, “Ms. Financial Representative, what difference does it make if I pay a front-end load or a back-end load? I don’t want to pay any sales commission!” The industry was already one step ahead of them.
“No problem, Mr. and Mrs. John Q. Investor! Our Class B shares have a Contingent Deferred Sales Change (CDSC). You only pay the back-end sales charge if you don’t hold on to the shares for 4 years. After that, there is no sales charge.” The representative is correct but she and her cohorts were often withholding an important piece of information. The Contingent Deferred Sales Charge does indeed reduce over 4 or 5 or 6 years. The first year, it may be 4%, the second year, 3%, and so on until the back-end sales charge disappears. However, what the sales representative did not divulge ‒ “But Ms. Jane Q. Investor, it was all contained in the prospectus that you read!” ‒ is that the Class B shares typically charge higher annual operating expenses over 6 or 8 years. Much of those higher annual operating expenses are going to compensate the advisor and their firm.
Where did the higher annual operating expenses come from? They came from the 12b-1 fees, of course! Doesn't everyone know that? Class B shares typically had 12b-1 fees that were four times higher than Class A 12b-1 fees. Over time, the Class B shares can wind up costing an investor more than the Class A shares. Plus, there is a point at which the sales charge breakpoint makes the Class A shares a much better deal for the investor than the Class B shares. This and a few other abuses of the Class B shares perpetrated by a number of financial representatives gave the Class B shares a less-than-stellar reputation. Many mutual fund companies have already done away with their Class B shares.
“Mr. Ron Q. Investor, you say you don’t want a front-end load nor a back-end load? No problem! We have the shares for you! They are called Broker No-load Funds.” The next attempt by the industry to counter the challenges of the no-load funds was the invention of the Class C shares. At the time, many representatives referred to them as Broker No-load Funds. That name is no longer allowed by the regulators. Class C shares have no front-end load and no back-end load except for a typical 1% back-end load that is charged if the investor withdraws the funds within one year. “But you are not going to withdraw your money within a year, Señorita Juana Q. Inversionista, right? Mutual funds are long-term investments.” However, like the Class B shares, the Class C shares have much higher 12b-1 fees for typically 8 or 10 years and therefore, they, too, can wind up costing far more than the front-load Class A shares. As with the Class B shares, most of those higher 12b-1 fees are used to compensate the client’s advisor.
As mentioned, the term Broker No-load Funds is no longer permitted to be used by investment representatives. Why is this? The Securities and Exchange Commission has ruled that Class C shares are a type of load fund. The only difference is that instead of front-end or back-end load, the mutual fund is charging the sales load yearly over time on an amortized basis.
So you go to your broker and you say, “I don’t want to pay a front-end load nor a back-end load and I want lower annual expenses.” What do you think your broker is going to say? Are you starting to see a pattern here? Can you guess what the first words out of the advisor’s mouth will be?
“No problem! For you, we have the new and improved Class F shares! And by the way, we are not your brokers anymore. Oh, no, no, no! We are your wealth managers, your investment advisors, your trusted personal financial consultants. We don’t charge commissions anymore!” The Class F shares go by various designations, Class FI, Class I, Advisor Class, and now, clean shares. These shares have no front-end load, no back-end load, typically no 12b-1 fees, and overall, have much lower annual operating expenses than the Class A, B, and C shares. If you are wondering where the funds to compensate the advisor are coming from, then you have been paying attention and are a good candidate for entering our industry as a professional. What has the sales representative left out of the conversation?
With the Class F shares, the advisors and their firms are tacking on an additional annual operating expense separate from the mutual fund expenses. Currently, it is typical for a brokerage firm to add an additional 1% or even 2% on top of the mutual fund annual operating expenses. With this additional charge, over time, the potential fees that a mutual fund investor pays dwarf the fees of the corresponding front-end load Class A shares, especially for those who can take advantage of the sales charge breakpoints available to Class A share investors. However, this is not the investment world of the 1960’s. If you seek the services of a personal investment advisor, chances are that they will want to pony up the additional 1% or 2% “wealth management fee.”
In addition, the wealth managers normally don’t want us, the Little Folk, who are putting $50 or $100 per month away into our Roth IRA. For example, one such firm, Fisher Investments wants you to have at least $500,000. With your $500,000 or more, you get charged 1.25% for the privilege of having them manage your money. According to a report from Investopedia, the average fee as of 2019 was 1.02%. As of this writing, larger firms are experimenting with more automated, less personalized, services and are offering lower annual operating expenses. One example of this is a company called Betterment that offers wealth management services for a fee that is between 0.25% and 0.40% of assets depending upon the size of the account.
The A, B, C, and F/I/FI/Advisor/Clean shares classes are only the beginning. Depending upon the mutual fund company, there may be many more share classes. Take heart. All of them are variations on one of the four share classes described above.
The very last share class consists of no-load funds. The financial media often refers to them as “true” no-load funds. This unofficial designation was meant to distinguish these funds from the so-called “broker no-load” Class C mutual fund shares. (Recall that the SEC now prohibits Class C shares from being called no-load funds.) The debate between load funds in all their many permutations and no-load funds will continue unabated for years to come. Remember that no two mutual funds are the same and some load funds have done better than some no-load funds over significant periods of time. Also recall that if you want the benefits of a financial professional, you should be expected to pay for it. One way is to pay of paying your financial professional is through sales loads, whether through Class A front-end shares, Class B back-end shares with a contingent deferred sales charge (CDSC), Class C shares with the load spread out of several years, or Class F/I/FI/Advisor/Clean shares with the additional wealth management, also known as the assets under management (AUM) fee.
A last word on paying for professional financial services is needed here. Some financial professionals are “fee-only.” This has added yet another option into the debate. Some in the industry argue that fee-only professionals do not have the same potential for a conflict of interest since the professionals are not being paid on commissions. However, there are various types of fee-only professionals and some do indeed earn a commission or an assets under management fee or both. Added to this confusion is that often the fees for fee-only advisors can be more expensive than paying the commissions on Class A front-end mutual fund shares.
Breakpoint Sales Charge Reductions and Contingent Deferred Sales Charges
The sales charge breakpoints for Class A shares are often overlooked as a potential powerful method to lower an investor’s costs over time. Below is a typical sales breakpoint schedule for Class A shares.
|
Investment (either purchased or accumulated) |
Sales Charge |
| Less than $25,000 | 5.75% |
| $25,000 but less than $50,000 | 5.00% |
| $50,000 but less than $100,000 | 4.50% |
| $100,000 but less than $250,000 | 3.50% |
| $250,000 but less than $500,000 | 2.50% |
| $500,000 but less than $750,000 | 2.00% |
| $750,000 but less than $1,000,000 | 1.50% |
| $1,000,000 or more | None |
As we can see from the table above, as we contribute more or as our account reaches higher levels, the sales charge on future purchases is reduced. Investors can even sign a Statement of Intention with their mutual fund company, agreeing to invest a sufficient amount to qualify for a certain breakpoint. The investor has 13 months to satisfy the statement. This allows the investor to pay fewer dollars of sales commission on their initial investments. For example, an investor might know that they will be able to invest at least $100,000 over the next 13 months. After signing the Statement of Intention, the investor could initially invest $10,000 now and only pay a 3.50% commission instead of the 5.75% maximum commission. If they fail to satisfy the statement of intention and the 13-month period expires, the mutual fund company will charge the commission that was waived.
In the past, some unscrupulous brokers would fail to mention the sales charge breakpoints provision to their clients. As the client reached a breakpoint, the broker would recommend that the client contribute to a different fund. Today, any broker that attempted this breach of fiduciary trust with their clients would have their license revoked as well as be liable for fines and restitution to be paid to the clients. Once again, we apologize on behalf of our industry and once again, it is the few bad apples that give all investment professionals a very bad name. By the way, “breach of fiduciary trust” is the investment industry’s gently ambiguous euphemism for, “fraud and theft.”
As mentioned, the Class B shares typically have a Contingent Deferred Sales Charge that is reduced over time until it disappears entirely. Below is a typical Contingent Deferred Sales Charge schedule. This type of schedule is also common with annuity investments in the insurance industry. However, the annuity schedules often last upwards of 20 years and can start at up to a 20% or 25% back-end fee.
| Year of Redemption | Contingent Deferred Sales Charge |
| 1 | 4.0% |
| 2 | 3.0% |
| 3 | 2.0% |
| 4 | 1.0% |
Fees and Expenses of Several Example Mutual Funds
It is now time to take an in-depth look at the fees and expenses of several sample mutual funds. If you have not done so, please listen or watch the second presentation of chapter 2 on the class website or on YouTube. Stick around for the denouement where we compare not only the fees but the investment results for four different mutual funds and compare them to an industry standard.
Pay special attention to the “checking for comprehension” slides at the end of the presentation. You need to be able to explain the subtle and obtuse differences between the various mutual fund share classes. Last, note that the share classes that we have described above and describe in the presentation are just the major share classes. There are many, many more! Luckily, all the other mutual fund share classes are simply variations on the themes that we cover here. Study and learn these thoroughly. Memorize them.
In the presentation, we see that there is a strong difference in the fees charged by actively managed mutual funds and passively managed index mutual funds. The simple reason a passively managed index mutual fund costs much less than an actively managed mutual fund is that the passively managed index mutual fund is doing absolutely no research and is not identifying, choosing, and monitoring the securities that populate the mutual fund. The index fund is simply reading from a list of stocks or bonds and buying them; if the stocks or bonds are not on the list; they don’t buy them. It’s that simple. On the other hand, the actively managed mutual funds have entire staffs of multilingual, multicultural portfolio managers and research analysts that need to span the globe to identify, choose, and monitor their investments. If done well, this is an expensive undertaking.
There is one exception to the rule about low-cost passively managed index funds. As your family’s, friends’, and most importantly, your colleagues’ Future Financial Wizard, you must be aware of this exception. Some employer-sponsored plans will try to sneak index funds into the plan with high fees. This is typical when the plan administrator is an insurance company. You may ask, “Who would do that to their employees?” One example is Southwestern Community College, the folks sponsoring this class. When the representatives from the new insurance company ‒ We won’t name any names ... Nationwide! ‒ came to tell us how wonderful our new employer-sponsored plan was, they didn’t plan on Your Humble Author being at the meeting. In the fund, they had snuck index funds with fees almost 10 times as much as index funds from other companies. I asked them why the index funds had such high fees and they were gob smacked and started stumbling and mumbling something about how they were working to find lower fee funds. They didn’t lie. They did replace the obscenely high-priced index funds with funds that were only very high priced, their own Nationwide brand funds. For several years, I complained and complained to my colleagues in our Human Resources and Benefits Department. It wasn’t that they didn’t care. They simply did not understand what the problem was. Finally, one of the women in the department took this class and exclaimed to me, “You are right! They are screwing us!” Soon after that, we moved to another insurance company that is screwing us much less. Dear Readers, never trust an insurance company with your investments. When we get to annuities, we will see how insurance companies are not always on your side." (Disclaimer: I am also a licensed insurance agent in the State of California.)Dear Readers, never trust an insurance company with your investments. When we get to annuities at the end of our journey together, we will see that when it comes to investments, insurance companies are usually not “on your side.” (Disclaimer: As well as a registered representative, aka stockbroker, I am also a licensed insurance agent in the State of California.)
This is where you come into the picture. When that slick financial representative in the three-piece silk suit with a $5,000 watch on his wrist tries to sell you on how wonderful your 401(k) plan is, you are going to ask him, “Why do we have a Nationwide index fund that costs 10 times more than a Vanguard or Fidelity index fund?” He will start to stammer and hem and haw and your colleagues will look at you with awe and admiration. And hopefully, your company will realize what absolute scoundrels these people are. When your colleagues are amazed and ask you how you became an Investment Guru, don’t forget to tell them about Introduction to Investments at Southwestern Community College. You’re welcome, by the way.
Comparison of Commissions versus Assets Under Management (AUM) Fees
In the presentation, we saw how a front-end load fund using Class A shares can cost an investor less in fees and expenses than the other share classes including the financial advisor “wealth management” shares. This difference can become enormous if the potential investor is eligible for the sales charge breakpoints. Later on in the chapter, we will discuss mutual fund illustrations, also called hypothetical illustrations or just hypotheticals. These are examples of the investment returns that mutual funds have produced in the past. We will run long-term hypotheticals for the same mutual fund at the $500,000 level, one using the traditional Class A shares and paying the front-end load, the other using the Class F shares without sales commissions but paying a typical 1.25% annual wealth management fee for assets under management. The differences in the final resulting amounts over 20 and 25 years are eye-opening.
Some investment professionals may cry foul here. We must acknowledge that we are making a major assumption here. We are assuming that the investor has a very long-term time horizon and does not plan to move their investments around often. If that is not true, then switching your Class A share investments every one, two, or three years would quickly generate large front-end load fees. We again reiterate that mutual funds should be considered long-term investments.
The same investment professionals might be quick to say, “Well, we don’t use the mutual fund in the example your class used. We use different investments.” If that is the case, then we would need to run hypothetical illustrations of their chosen investments, one with the front-end commissions and one with the annual wealth management fee. Again, if the investor has a long-term perspective and intends to buy and hold their investments, the commission fee structure will normally be less costly than the annual wealth management fee.
The Bottom Line on Fees
Fees and expenses are very important, but they certainly do not tell you the whole story about a mutual fund. When comparing mutual funds, you must look at many attributes, not the least of which are the rates of return, preferably over long, statistically significant time periods. Many financial advisors will say that a 10-year period is far more than enough to evaluate mutual funds. However, even 10 years might not be a long enough time period to evaluate your potential mutual funds. There are 10-year periods where some types of mutual funds do very well while others languish. Those times are often followed by a subsequent 10-year where the reverse is true. Look for companies with track records of 20, 30, or even 50 or more years of successful investing. We will do this as an assignment in a later chapter. In our next section, we will try our best to do the impossible. We are going to try to get our arms around the mutual fund industry and identify the major categories of mutual funds. Wish us luck. It’s not easy!