A cousin of mine recently went to a bank to open a Roth IRA. He figured by going to the bank he would get a fair deal with low fees. “They have free checking”, he told me. The bank had set it up so that he would make $400 per month payments right from the checking account into the Roth IRA. So, why did he come to me? Something odd seemed to be happening with his contributions. $20 of every payment was vanishing into thin air. Or, more likely, into the salesperson pocket. And what is worse, this may not even be the worst fee he was paying. This post addresses mutual fund fees and how to avoid being ripped off by a high fee mutual fund or salesman.
From load to no-load
I’m not sure it is better to call something a load or a fee, but they are essentially the same thing. A load is a sales charge that a salesperson will collect for “selling” a mutual fund. For example, the $20 that my cousin saw disappearing from his account each time he made a contribution. That was a 5% load being paid directly to the bank and salesman. This is considered a front load, which means the commission comes out before actually buying the fund. Typically, these fees can range from 1% to 5%, depending on how much you purchase. For example, if you use $250,000 to buy a fund, you may only have a 1% fee or less. My cousin who was buying $400 at a time, was being charged 5% per deposit. In other words, he was getting ripped off.
Now, not all loads are charged in the front. Class A shares typically have a front end load. B shares don’t have a front end load, rather a back end load. Yes, your mutual fund can have a little junk in the trunk. Back end load mutual funds actually charge a fee when you sell. Typically, the back end load will start fairly high, maybe 5.5%, but the penalty goes down each year until it could be gone completely. The longer you own it, the lower the fee.
Loads are complicated and not all A or B shares will have a load. There is a good chance that if you are using a broker, a.k.a commission salesperson, you will be charged a load. Other fee-only financial advisors who charge a quarterly fee, probably don’t also collect a load. The best way to find out if you are being charged a load, ask your financial advisor. If you are buying mutual funds on your own, without an advisor, you probably are not paying a load.
Loads are only half the battle though with mutual funds.
Remember how I told you that the load my cousin was paying wasn’t even the worst fee? He was also paying nearly 2% per year to the mutual fund company! If you own a mutual fund long enough, loads may not have a huge negative impact. However, the expense ratio is charged every year no matter how well a fund is performing. He wasn’t just getting hit by a fee he saw (load) he was also being crushed by a high expense ratio that he never even knew existed.
Expense ratios are the hidden fees that all mutual funds and Exchange Traded Funds (ETFs) charge. Well, that is until recently when Fidelity came out with no expense ratio ETFs, which is pretty incredible. These fees could range for 0.10% in an index fund to over 2% per year in a high cost actively managed mutual fund. Typically an expense ratio will range between 0.5% to 1% is common. My cousin was paying even more. This is a fee that you will never see. Rather the expense ratio impacts the overall performance. For example, let’s say that a mutual fund invests in stocks that go up 10% in a year. If there is a 1% expense ratio, then the owner of that mutual fund would only see a 9% rate of return. Usually this fee is paid monthly, and again you never even see it come out of the account.
Morningstar.com is a great way to research mutual funds and determine the expense ratio.
High Expense ratios have killed performance for investors and have made many mutual fund companies very rich. One of the first things you should do if you own, or are buying mutual funds, is to research the expense fees. The lower, the better.
Thought we were done with fees? Not quite yet. Many companies such as TD Ameritrade, Fidelity, and Charles Schwab offer mutual funds that they claim are no fee and have no transaction costs. Many times these are marketed as “no-load” mutual funds. Sounds like a pretty good deal, right? There is almost always a catch if it sounds too good to be true in the financial world. Many times the reason that you can buy these funds with no fees, is because the mutual fund is actually paying these custodians, like Fidelity. They pay these companies through what is called a 12b-1 fee. The 12b-1 fee is basically a marketing fee, and you the owner of the mutual fund is actually paying it. Now, when you look at an expense ratio of a mutual fund, this includes the 12b-1 fee.
Mutual Funds are chalked with fees, but the good news is that these fees are actually starting to go down. According to Morningstar the average fund fee declined 8% in 2017 to 0.52%. As more index funds and ETFs become prevalent, there is a good chance that these fees will continue to go down. The bad news is that there are still those financial advisors that will try to rip you off with high loads and high expense ratio mutual funds. Knowing how much you are potentially going to pay in loads and expenses can help make sure that you are not being taken by a financial advisor.