How Important Are Mutual Fund Fees?

There are a number of fees associated with mutual funds beyond taxes on the gain. Perhaps because most of these fees are relatively hidden, or maybe people just don’t realize what they are, they are often not taken into account when selecting mutual funds. Unfortunately for these people, what they don’t know may be costing them big bucks.

Common Fund Fees

  1. Purchase or Redemption Fees
    Also called front/back loads or front/back end fees, these are usually a fixed percentage charged either when you deposit or withdraw the money. I’ve also seen these described as a “Sales charge” or “Deferred sales charge”. Bottom line, these fees are usually in the 5% range and are taken directly from the amount deposited or withdrawn. In other words for every $1000 you invest, $50 will be subtracted from your account.
  2. 12b-1 Fees
    These are also known as distribution and service fees. They can go towards a number of different things, but are generally used to cover operating and servicing costs of a fund. 12b-1 fees have been justified on the basis that they can be used to bring more money into the fund or used for recruiting to attract better fund managers. There is some debate however on whether or not this actually is true or is just used as a way to skim more money from the investor. I say they’re just another way for fund companies to nickel and dime you and should be avoided.
  3. Management Fees
    These usually go to the account broker (not the fund company) and are used to cover the cost of maintaining the account, paying agent commissions, etc.

So that you don’t have to keep track of lots of different fees, 12b-1 and other management fees are all rolled into one number, the expense ratio. This is the number to look for, although it doesn’t include the purchase, redemption (sale), brokerage, or trading fees (if applicable).

Aren’t Taxes Higher?

uncle-sam

I suspect that most people ignore the fees associated with mutual funds because they seem minimal. After all, who really cares about an extra 1.5% when capital gains tax is 15% at best? The problem lies in what the fees are applied to. Capital gains tax is applied to the gain in value in the fund, whereas all the other fees are applied to the total account balance, regardless of whether or not your account is up for the year.

Say on January 1st you invest $10,000 in a fund that ends the year up 10%, a reasonable rate of return. Before any taxes or fees are taken out at the end of the year you will have $11,000 in your account. Congratulations, you’ve just gained $1,000.

Before you go off and celebrate, don’t forget that Uncle Sam will want his share. Depending on your income and how long the shares within the fund were held, the IRS will require up to 35% of the gain in value. For the sake of illustration, however, let’s assume you’ll be taxed at a 15% rate (at the time of this writing). 15% of the $1,000 gain is $150.

Now let’s take a look at what you’re paying the mutual fund company… Since the expense ratio is applied to your total account balance, you will pay 1.5% of $11,000, or $165. Note that this is actually higher than the taxes paid. A 1.5% expense ratio carries the same cost to you, the investor, as a 16.5% tax from the government on a 10% return. Now does it seem worth paying attention to?

A Better Alternative…

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Low cost funds rock. Vanguard’s website advertises that their average mutual fund expense ratio is 0.2%. Compared to the 1.5% fund from my example, this will save you $143/year on a $10,000 investment. To see the same overall gain you would need to earn an extra 1.7% on your investment. (I wish I could get paid for promoting Vanguard).

Summary

I have to laugh at a financial adviser who once bragged to me about how the funds they were selling had zero 12b-1 fees. These same funds had a 5% front load and around a 2% annual expense ratio. Unfortunately at the time I didn’t know how much that 2% would cost me, but other factors prompted me to start looking for another place to put my stash.

Currently we are maxing out our Roth accounts. If we continue to do this for the next 20 years (total around $200k invested) and average a 10% annualized return, we will have about $614k in the accounts at a 0.2% expense ratio, vs $525k if the expense ratio were 1.5%. That’s a difference of almost $90k, simply by minimizing expenses. $90k will buy a very nice wakeboard boat. In order to have the same balance at the higher expense ratio, we would need to earn 11.3% annualized.

I realize that many people want a hands off approach to investing (although those people have probably long ago hit the back button in their browser). If that’s you and you want to boost your returns, move your money into a low cost fund such as Vanguard 500 Index Fund Admiral Shares (VFIAX) which will charge 0.05%.*

References

Mutual Fund Fees and Expenses (SEC.gov)
http://en.wikipedia.org/wiki/Mutual_fund
http://en.wikipedia.org/wiki/Capital_gains_tax_in_the_United_States

*Disclaimer

Ultimately it’s your responsibility to decide what is best for you. This is just my own opinion, although numbers don’t lie.

3 thoughts on “How Important Are Mutual Fund Fees?

  1. Pingback: A Closer Look at Cash Value vs Term Life Insurance | David Wahl

  2. Great post about mutual fund fees. I agree with you about Vanguard, once you do your research, it’s really just funny how other people still use financial advisers with fees 20X more expensive!

  3. And when a portfolio gets to be a decent size we’re talking about major money. That 2% will cost $20,000/year on a million dollar portfolio, I certainly haven’t met one yet who I’d be willing to pay $20,000/year, yet that’s what people are effectively doing.

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