Understanding How Mutual Fund Fees are Structured

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Those of you who are looking to get started in the stock market may have no idea where to start when it comes to picking stocks. You may know that the general rule of thumb is to diversify. That’s what everyone means when they suggest not to put all your eggs in one basket. The reasoning is to limit the amount of exposure to any one stock. But how do you go about it?

You may wonder how you could diversify when you only have a limited amount of funds. You might have heard of the term mutual funds, which is one of the most popular forms of diverse investing. However, before you invest in any mutual fund, you need to understand how they work and be aware of the fees associated. Here, I will go over what to look for.

A mutual fund is where investors pool their money together which is then managed by professionals to try and earn capital gains on their investments. Picking which one to invest your money depends on whether you share similar philosophies and the type of investing strategy they implement. Before investing in mutual funds, you need to make sure you are knowledgeable about them so that you can make educated decisions and not be surprised by any costs. Quite honestly, that applies to pretty much everything. After all, knowledge is power. Below, I’ll talk about the costs associated with mutual fund investments.

EXPENSE RATIO

Since there are people managing and running the fund, there are operating expenses. Investors are charged an expense ratio. Simply put, it’s just the ratio of the fund’s total operating expenses to its total assets. If you invest $10,000 in a mutual fund with a 1% expense ratio, you pay $100 to cover the fund’s operating expenses. Oftentimes, the expense ratio correlates with the level of trading activity of the managers. If it is an actively managed fund, then it’ll require more time and research from managers, meaning you’ll have to pay them more.

SALES CHARGE

Some companies include sales charges, or commissions, when you purchase or sell mutual funds. There are the front-end loads, which is the fee that you pay upon purchase of a share. There are also back-end loads, which you pay upon sale of the share. Some mutual funds don’t charge any upfront fees, also known as a “no-load fund.”

There are Class A shares, which normally come with front-end loads. Then there are also Class B and Class C shares, that usually come with back-end loads. Later on, I’ll get into the nitty gritty of specific types of mutual funds, and the best ones for your personal portfolio. Everyone’s financial situation is different, so there will be different kinds of mutual funds that tailor to your strategy.

REDEMPTION FEES

Redemption fees are another fee that you pay if you sell the share after within 90 days. Since mutual funds are created for long term investing, redemption fees are charged to discourage any short-term buying and selling. These are not to be confused with back-end loads. Back-end loads are sales commissions paid to a broker. Redemption fees are paid to the fund to discourage investors from early withdrawal.

MY OPINION

Ideally, you’re paying more in fees and higher expense ratios in hopes that this extra due diligence from the portfolio manager will result in higher returns. Personally, I prefer passively managed funds because of the lower costs. Index funds are an example of passively managed mutual funds. To put it very simply, index funds mimic the stocks inside an index, such as the S&P 500. Historically, most fund managers are unable to consistently beat the market over the long term, so why pay the extra fees associated with actively managed funds, whose primary goal is to outperform the total stock market? The key is buying and holding. Say it with me, “buy and hold.” If you only get one thing out of this article, please understand how important it is to buy and hold. Do not attempt to time the market.

Make sure you do your due diligence to find out the type of fees that are charged to you. They can take a huge bite out of your investment. If you don’t want to have to pay hefty sales charges, you can buy mutual fund shares directly from the company themselves. That way, there is no necessary middleman, such as a broker or financial planner, to pay any type of sales commission to. Don’t just automatically assume that no-load funds are better though. They may have no sales charges, but it could have a higher expense ratio. Just be aware of how the fee structure of the fund works.

These are the main fees associated with investing in mutual funds. Be as knowledgeable as you can about the mutual fund and whether it’s the right one for you. There is still a lot more to know about mutual funds, but let’s take it slow. In the near future, I’ll talk about types of mutual funds, where to buy them, which ones are the best for you depending on your situation and risk tolerance, and if they play a part in my personal portfolio.

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