It shouldn’t surprise you that people in the business of investing money like to make money themselves. And that’s fine! As a consumer you should understand how your investments charge you and whether the price is reasonable.
Today I’ll discuss two common ways that mutual fund companies make money: Loads and Expense Ratios.
Loads are a way to pay your adviser for selling you the mutual fund. The two most often sold types of load funds use front-end loads (called A shares) or back-end loads (called B shares).
Front-end load funds typically charge 5%-6% in upfront commissions. So, if you invest $2,000 in a mutual fund with a 5% front-end load, $1,900 will be invested and $100 will go to your advisor. The mutual fund then needs to make $100 in investment returns before you break even.
Back-end load funds (B shares) try to keep you in the investment longer by charging you on a sliding scale to sell the fund. For example, a 5% back-end load fund might charge you 5% to sell your fund within the first year of buying it, 4% in the second year, and so on until year 6, when you can sell the fund with no fee.
No-load funds do not charge commissions to buy and sell. They are usually sold through discount brokerages or salaried employees of the mutual fund company. Regardless of whether you buy front-end, back-end or no-load mutual funds, there will always be an annual expense ratio.
Expense ratios are a percentage of the value of the fund that is taken out every year to cover the management fees and profits of the mutual fund company. For example, if your fund has an expense ratio of 1% and you have $100,000 invested for the full year in that fund, you will pay $1,000/year for the fund management.
Expense ratios come out of your investment whether or not the fund makes money. The employees of the fund company have to get paid if the markets or up or down. The returns that the fund reports making already have the expenses deducted out. That means what is reported is the true return that investors receive.
Different mutual fund categories (i.e. US Large Stocks, Foreign Bonds) cost different amounts to manage. Next week, I’ll show you some acceptable ranges for expense ratios in different areas of the investment markets.