As our series on mutual funds continues, they are probably sounding like a pretty good way to save and invest, but remember there are always at least two sides to every story, so let’s now examine the disadvantages. The biggest disadvantage of using mutual funds for your investments is the range of fees they charge and expenses they accrue to manage the fund. These costs can significantly reduce your earnings. 1.5% costs may seem small, but if a mutual fund had a 7.5% total return, then its 1.5% expense ratio would reduce your earnings by 20%.
Here is an example from an SEC.gov publication:
If you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858 — an 18% difference.
Buying and selling individual stocks result in relatively small fees only when you buy and sell them, while mutual funds’ expenses reduce your returns as long as you hold the fund shares – regardless of whether the price goes up or down. There are a wide variety of fees when you buy and sell a fund and annual expenses eat at your returns indefinitely. Here is a list of the most common.
Some funds charge a fee, called a “load”, when you buy or sell the fund. These loads are paid to the agent who sells you the fund and can range up to 8.5%. These types of funds are called “front-end” or “back-end” load funds depending upon when they charge you the load/fee. Think about how extraordinary these funds would have to perform to overcome that 5 – 8.5% load — and then avoid them! You can always find plenty of “no-load” funds that do at least as well without handicapping yourself with a hefty up-front fee that is going to be difficult to overcome later. Paying fees reduce your returns. Don’t make it worse by buying “load” funds.
Additionally, all funds, including no-load funds, have a variety of other fees and expenses needed to run the company including: purchase and redemption fees, exchange fees when exchanging funds within the same company, account fees for maintaining your account, management fees, 12b-1 fees for advertising etc, distribution fees, service fees, and “other” expenses. Funds may have several classes of shares (A, B, or C) each with a different level or combination of these fees and expenses.
Our next blog will cover how to choose mutual funds, but for now it should be obvious that you want to look for funds that minimize these fees. Remember that the worst fund fees are also the easiest to avoid — don’t buy “load” mutual funds.