# 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.”

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.

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.

# 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!

This page titled 2.6: Fees, Expenses, and Share Classes, Oh, My! is shared under a CC BY-NC-SA 4.0 license and was authored, remixed, and/or curated by Frank Paiano.