Thursday, November 10, 2011

Fund Costs


Mutual Fund companies are not running charity and they have to ensure that they make money. For this reason, all mutual funds charge fees, but these charges for mutual funds come right off the top of your investment or straight out of your returns. Because costs are deducted this way, many investors aren't even aware of how much they're paying for their mutual funds.

Fund’s expense ratio can range from 0.2 percent of assets annually for the lowest caost equity fund to 2.5 percent for highest cost equity fund. So the question here is – Does a percentage point or so really matter?

Fund’s Total Return – Cost = Fund’s Actual Investor return.

Years
High Cost 10% Return
Low Cost 11.9% Return
10
25900
30800
25
108300
166200
50
1173900
2763800

In fact each percentage point reduction in cost, on average, increased the returns of a bond mutual fund by over 1.2 percent and increased the returns of large cap blend mutual fund by 1.8 percent. Before you invest in a fund, you should look at the expense ratio that they charge because costs really matter and they can take bite off your returns.

Mutual fund fees can be broken down into two main categories: one-time fees and ongoing annual expenses. Not all funds charge one-time fees, but all funds charge ongoing annual fees of some sort.


One Time Fees

1.     Sales Commission A.K.A. Loads.
If you have to pay a sales charge, or commission, when you purchase shares in the fund, that's known as a front-end load; a sales charge when you sell is a back-end load. Loads come directly out of your investment, effectively reducing the amount of money that you're putting to work. For example, if you made a $10,000 investment in a fund that carried a 4.5% front-end load, only $9,550 would be invested in the fund. The remaining $450 would go to the advisor or broker who sold you the fund.
But do load funds offer superior returns in order to justify the expense of the load? There is no evidence to suggest that this is the case. However, you probably shouldn't just disregard a mutual fund because it has a load. On the stock side, a load fund may make a perfectly fine investment, if you're a long-term investor. But load-fund investors should look for funds with fairly low annual costs, such as those sponsored by American Funds. Their total costs (including sales fees) over a period of years are actually more moderate than those of many no-load funds.

2.     Redemption Fees.
Redemption fees differ from loads in that they are usually paid directly to the fund—in other words, they go back into the pot rather than to the broker or advisor. You may have to pay a redemption fee if you hold a fund for only a short period of time. In most cases, this time frame is less than 90 days, but it can be as long as a few years. These fees are an attempt to discourage short-term traders from moving in and out of a fund and that it enables the fund managers to invest the money more confidently, without having to keep a large amount of cash reserves ready for redemptions.

3.     Account-Maintenance Fees.
Some fund companies charge account-maintenance fees, but such fees are usually for smaller accounts. Vanguard funds, for example, charge shareholders a $10 account-maintenance fee if their account balances dip below $10,000, Trowe Price has some charge, etc.

4.     Transaction Fees.
Some brokers and fund companies charge transaction fees specially if you buy a fund that is not the product of the company e.g. TD Ameritrade charges 50$ for some funds, Scottrade charges 17$ for some, etc.


Ongoing Expense

1.     Management Fees.
Mutual funds charge management fees in order to pay for the management services used to run the fund. In other words, these fees are used to pay the salaries of the fund's managers and analysts. Management fees usually do not amount to more than one percent of the fund's assets, and they are significantly lower for passively-managed funds, such as index funds, than for actively-managed ones . You should remember that a high management fee in no way guarantees a more skillful management team.

2.     12b-1 Fees.
12b-1 fees, also sometimes called "distribution fees", pay for any marketing and advertising expenses that the fund incurs. They are called 12b-1 fees because that is the number of the SEC rule that allows mutual funds to charge them. No-load mutual funds often have higher 12b-1 fees because they do not charge sales commissions. You should always look at 12b-1 fees in conjunction with sales load.

3.     Interest Expense.
If a fund borrows money to buy securities—not a very common practice among mutual funds—it incurs interest costs. This is particularly common in mutual funds that engage in long/short strategies. Such expenses are also taken out of the shareholders' annual return.


So the bottom line is that the cost matters. With risk constant the high returns are directly associated with low cost. In large cap blend fund the average risk adjusted return provided by low cost fund is 24 percent higher than that of high cost fund. 

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http://www.mutualfundsforfuture.com

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