Thursday, July 9, 2009

Mutual Fund Costs and Share Classes

Most of us are hard-wired to perceive high-cost items as being more valuable than lower-cost alternatives. While that might be true in some areas of life, when it comes to investing in mutual funds, selecting funds with low expenses is a great way to increase your chance of investing success.

Numerous studies have shown that mutual funds with low expenses tend to outperform funds with high expenses over time.

The world of mutual fund investing can be broken down into two groups: no-load (no commission) funds and loaded (commission) funds. No-load funds charge an expense ratio that includes a management fee and 12b-1 fee, although many no-load funds don’t charge 12b-1 fees. Loaded funds - classified as either A, B, or C shares - charge expense ratios and pay various types of commissions to the advisors that sell them.

Expense Ratio: Includes the management fee and any 12b-1 fee that is charged. All mutual funds will have an expense ratio.

Management Fee: Pays the fund manager and covers record keeping, accounting, auditing, and other expenses. All mutual funds will have a management fee.

12b-1 Fee: A sales charge that is paid to the selling agent to cover marketing of the fund. By law, no-load funds can’t charge a 12b-1 fee over 0.25%, but loaded funds can accept 12b-1 fees.) All loaded funds will have 12b-1 fees, but many no-load funds will not have 12b-1 fees

Loaded mutual funds (funds that charge commissions) will be classified as A, B or C shares.

Class A Shares: Charge an up front commission, deducted from your initial investment, that usually starts around 5.75%. Discounts, or “breakpoints”, are available under certain circumstances. A shares can be “load waived” as well, meaning the front end load is waived, but 12b-1 fees still apply.

Class B Shares: Charge a back-end commission starting around 5% that declines over 5 to 10 years until eliminated. B shares charge a high 12b-1 fee to compensate for the commission paid to the selling agent.

Class C Shares: Usually charge a 1% back-end load if sold within the first year. C shares charge a 12b-1 fee of 1.00% that goes to the selling agent. Don’t let an advisor tell you that a Class C share is a “no-load fund”! It isn’t!

Now that you know the various fees charged by mutual funds, you can look at your portfolio and figure out what you’ve been paying.

My advice is to avoid loaded mutual funds in favor of no-load funds with low expense ratios and no 12b-1 fees. Those are the types of funds I purchase for myself and recommend to my clients.

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