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Mutual Funds — A complete, but concise, tutorial about mutual funds in a one-page format with sidebars, illustrations, formulas, examples, and clear definitions of basic terms.
As with any business, running a mutual fund involves costs — including shareholder transaction costs, investment advisory fees, and marketing and distribution expenses. Investors pay these fees and expenses, which lowers their returns. Some funds impose loads directly on investors whenever they buy or sell shares. No load funds do not charge sales loads. In addition, every fund has regular, recurring, fund-wide operating expenses, which are paid out of fund assets. SEC rules require funds to disclose fees and expenses near the front of a fund's prospectus in a fee table, such as this:
Shareholder fees are paid directly by the investor.
Sales Load is the commission that you pay when you buy shares in a mutual fund. Also known as a front-end load, this fee typically goes to the brokers that sell the fund's shares. Front-end loads reduce the amount of your investment. For example, let's say you have $1,000 and want to invest it in a mutual fund with a 5% front-end load. The $50 sales load comes off the top, with the remaining $950 invested in the fund. According to NASD rules, a front-end load cannot be higher than 8.5% of your investment.
Many mutual funds with sales loads offer more than one class of shares, such as Class A and Class B shares. Each class will have the same portfolio of securities, investment objectives, and policies, but each class will have different shareholder services and/or distribution arrangements with different fees and expenses. As a result, each class will likely have different performance results.
A multi-class structure offers investors the ability to select a fee and expense structure that is most appropriate for their investment goals (including the time that they expect to remain invested in the fund). Here are some key characteristics of the most common mutual fund share classes offered to individual investors:
Class A Shares typically impose a front-end sales load with a lower 12b-1 fee and lower annual expenses than other mutual fund share classes. Some mutual funds reduce the front-end load as the size of the investment increases. Class A shares are best for the long-term investor. If you're considering Class A shares, be sure to inquire about breakpoints, which are only available for class A shares.
Class B Shares do not have a front-end sales load, but have a higher 12b-1 fee and a contingent deferred sales load (also known as a CDSC or CDSL or a back-end load)—this fee pays brokers to sell the fund's shares. This fee steadily declines to 0 within 6 to 8 years, then is automatically converted to Class A shares with a lower 12b-1 fee.
Class C Shares — Class C shares have higher expenses, no front load, but a back-end sales load if redeemed within a year, but the back-end load for Class C shares tends to be lower than for Class B shares. Unlike Class B shares, Class C shares do not convert to another class. Class C shares tend to have higher annual expenses than either Class A or Class B shares. These shares would be more attractive to a short-term investor.
These are the major classes, but there may be more, as you can see from the example of share classes from an actual prospectus:
A fund with a sales load will usually offer breakpoints in the sales load, where decreasing sales load ratios apply to larger purchases of Class A shares. Buying a number of shares that exceed a breakpoint will reduce the sales load percentage that would apply below the breakpoint. A fund does not have to offer breakpoints, but if they do, it must be disclosed in the prospectus. Here's an example of breakpoints from a prospectus:
Although breakpoints apply to a one-time purchase of class A shares, 2 other ways that some funds allow to qualify for breakpoints over a period of time are the Letter of Intent and Rights of Accumulation.
An investor, lacking enough money to buy enough shares at one time to qualify for a breakpoint, can sign a letter of intent (LOI), stating his intentions to buy enough additional shares over the next 13 months to qualify for a specific breakpoint. By so doing, the investor benefits from an immediate reduction in the sales load, with more money invested for potential profits. If an investor has already bought shares within the past 90 days without signing an LOI, he can still reduce the sales charges already paid by backdating the LOI by 90 days, but, because the time span of a LOI cannot exceed 13 months, the investor must reach the breakpoint within the remaining term of 10 months.
An LOI does not require the investor to reach the breakpoint, but if the investor fails to buy enough shares over the 13 month period, then some of his shares, which will have been escrowed by the custodian of his funds, will be liquidated to pay the higher sales load that would have applied without the LOI.
To reach a breakpoint under the LOI, the total amount needed to reach the breakpoint must be actually invested—market appreciation of held shares does not count.
An investor who does not have enough money to qualify for a breakpoint either by a one-time purchase or by signing a letter of intent may qualify for a breakpoint by buying enough shares over a long period of time—rights of accumulation. There is no time limit. When the investor purchases more shares that, combined with what he has already invested, is enough to qualify for a breakpoint, then the investor pays the reduced sales load for those shares, but only on the shares just purchased. The reduced sales load does not apply to prior purchases. However, in contrast to the letter of intent qualification, rights of accumulation does take into account market appreciation. Thus, if an investor wanted to make another investment to qualify for a breakpoint at $20,000, and he has $10,000 invested, and $1,000 additional earned by market appreciation, if he had signed a letter of intent that covered the initial $10,000 purchase, he would have to invest an additional $10,000 plus fees to qualify for the reduced sales load, but he would get a reduced sales load on his entire investment. If he wanted to qualify through rights of accumulation with his purchase, he would only have to invest $9,000 plus fees, but the reduced sales load would only apply to the $9,000 purchase.
No load funds do not charge a front-end sales charge or a deferred sales charge, such as a CDSC. NASD rules also require that the 12b-1 fees not exceed 0.25% of the fund's average annual net assets in order to call itself a no load fund. No load funds can, however, charge purchase, redemption, exchange, and account fees.
A purchase fee is sometimes charged when shareholders buy shares. Unlike a front-end sales load, a purchase fee is paid to the fund—not to a broker—to defray some of the fund's costs associated with the purchase.
A fee that some funds charge their shareholders when they sell or redeem shares. Unlike a deferred sales load, a redemption fee is paid to the fund—not to a broker—to defray fund costs associated with redemption.
A fee imposed sometimes if shareholders exchange (transfer) their shares to another fund within the same fund group or family of funds.
An account fee is separately imposed by some funds on investors in connection with the maintenance of their accounts. For example, some funds impose an account maintenance fee on accounts whose value is less than a certain dollar amount.
Operating expenses do not include shareholder fees, and are paid out of fund assets rather than being billed directly to the shareholder.
Paid out of the fund assets, management fees include payments to the investment adviser for portfolio management, any other management fees payable to the fund's investment adviser or its affiliates, and administrative fees payable to the investment adviser that are not included in other categories.
Paid out of fund assets to cover the costs of marketing and selling fund shares to new investors, and sometimes to cover the costs of providing shareholder services. Distribution fees include fees to compensate brokers and others who sell fund shares and to pay for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature.
12b-1 fees cover expenses for providing information to shareholders about their investments. Mail, telephone, and especially the Internet are the major distribution channels for such information.
Includes all expenses not subsumed under another category, including custodial expenses, legal and accounting expenses, transfer agent expenses, and other administrative expenses.
Operating expenses, such as management fees, 12b-1 fees, and administrative fees, but not including shareholder costs, such as the buying and selling of fund shares (sales loads), can be summarized by the expense ratio:
| Mutual Fund Expense Ratio Formula | |
| Total Operating Expenses (doesn't include shareholder costs) Average Net Asset Value | = Expense Ratio (.18% < Typical Range < 2%) |
The expense ratio is an important metric when comparing funds, because it can make a significant difference over time. Any money paid for expenses is money that is not invested and earns no profit. High expenses are not proportional to better management. In fact, frequently, high-expense funds underperform index funds, which are minimally managed and have very low expense ratios. A fund's managers can become rich just by charging expenses even as the fund's NAV declines!
If you are going to buy a large number of shares from a fund with a front-end sales load, then know if you can take advantage of breakpoints to lower the sales load percentage.
No-load funds do not charge a sales load, which is technically a sales commission to a broker for selling the shares, and therefore the no-load category may include fees that are not technically sales loads, such as purchase fees, redemption fees, exchange fees, and account fees. No-load funds will also have operating expenses.
Small differences in fees can translate into large differences in returns over time. For example, 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.
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