Investors should consider the effect that fees, expenses, and taxes will have on their returns over time. They can significantly reduce the returns on mutual funds and ETFs. As with any business, running a mutual fund or ETF involves costs. Funds pass along these costs to investors by imposing fees and expenses.
Shareholder fees are fees charged directly to mutual fund investors in connection with transactions such as buying, selling, or exchanging shares, or on a periodic basis with respect to account fees. An investor can find these fees and charges listed in the “Fee Table” section of a mutual fund’s prospectus under the heading, “Shareholder Fees.” ETFs do not charge these fees directly to investors, but they may have several types of transaction fees and costs, which are described below.
Operating expenses are ongoing mutual fund and ETF costs such as investment advisory fees for managing the fund’s holdings, marketing, and distribution expenses, as well as custodial, transfer agency, legal, and accountant’s fees. Operating expenses are regular and recurring fund-wide expenses that are typically paid out of fund assets, which means that investors indirectly pay these costs. These expenses are identified in the “Fee Table” section of a mutual fund’s or ETF’s prospectus or summary prospectus under the heading, “Annual Fund Operating Expenses.”
Although these fees and expenses may not be listed individually as specific line items on an account statement, they can have a substantial impact on an investment over time. Fees and expenses vary from fund to fund. If the funds are otherwise the same, a fund with lower fees will outperform a fund with higher fees. Remember, the more investors pay in fees and expenses, the less money they will have in their investment portfolio. As noted above, index funds typically have lower fees than actively managed funds.
Sales Charge (Load) on Purchases are a fee some mutual funds charge investors when they buy shares, also known as a front-end load. This fee is typically paid to the broker that sells the mutual fund’s shares. In this respect, a sales load is like a commission investors pay when they purchase any type of security (like a stock or an ETF) from a broker. Front-end loads reduce the amount of an investment. For example, let’s say an investor has $1,000 and wants to invest it in a mutual fund with a 5% front-end load. The $50 sales load the investor must pay comes off the top of the investment leaving the remaining $950 to be invested in the mutual fund.
Purchase Fee. Some mutual funds charge this fee to investors when they buy shares. Unlike a front-end sales load, a purchase fee is paid into fund assets (not to a broker) and is typically imposed to defray some of the mutual fund’s costs associated with the purchase. This fee is often imposed by a mutual fund that has high transaction costs, for example, because of its investment strategy. The fee is designed so that the other investors’ investments in the mutual fund are not diminished by the transaction costs of the purchase. Like front-end sales loads, purchase fees reduce the amount of the investment.
A Deferred Sales Charge (Load) is a fee some mutual funds charge investors when they sell or redeem their shares, also known as a back-end load. This fee is typically paid to the broker that sells the mutual fund’s shares. The most common type of back-end sales load is the contingent deferred sales load (also known as the CDSC or CDSL). The amount of this type of sales load will depend on how long the investor holds his or her shares. It typically decreases to zero if the investor holds his or her shares for a specified period.
When an investor purchases shares that are subject to a back-end sales load rather than a front-end sales load, no sales load is deducted at purchase, and all of the investors’ money is immediately used to purchase fund shares (assuming that no other fees or charges apply at the time of purchase). However, a back-end sales load will reduce an investor’s return on the investment. Typically, a fund calculates the amount of a back-end sales load based on the lesser of the value of the investor’s initial investment or the value of the investment at redemption.
A Redemption Fee is a fee some mutual funds charge investors when they sell or redeem their shares within a certain period of purchasing the shares. Unlike a deferred sales load, a redemption fee is paid into fund assets (not to the broker) and is typically used to defray fund costs associated with an investor’s redemption. The SEC limits redemption fees to 2%.
An Exchange Fee is a fee some mutual funds charge investors when they exchange (transfer) their investment to another fund within the same fund group or family of funds.
An Account Fee is a fee some mutual funds charge 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.
Finally, you may be subject to Brokerage Commissions. ETF investors typically pay their broker’s sales commissions with each purchase or sale of ETF shares, although some ETFs may be available commission-free. In this respect, a commission is like a sales load investors pay when purchasing or redeeming a mutual fund. Like front-end sales loads, brokerage commissions on a purchase reduce the amount of the investment. Like back-end sales loads, brokerage commissions on a sale reduce an investor’s return on the investment.
A brokerage commission may be structured as a flat fee charged every time an investor trades. With a flat fee, the smaller the amount traded, the larger the percentage cost per trade is. Investors should consider the fee structure of a commission when purchasing or selling ETF shares. Check with your broker regarding these fees. Brokers should provide written notice to customers of these charges when accounts are opened and when any of the charges change.
Bid-ask spread. ETFs and other securities that trade on a securities market actually have two market prices—the bid price and the ask price. The term bid refers to the highest price a buyer will pay to buy a specified number of ETF shares at any given time. The term ask refers to the lowest price at which a seller will sell the ETF shares. The bid price will be lower than the ask price and the difference between two prices is called the spread. An example is an ETF share that is trading for $59.50/$60. The bid price is $59.50, the ask price is $60.00, and the spread is 50 cents.
If an investor buys 200 ETF shares at the ask price of $60 and sells them immediately at the bid price of $59.50, the investor would incur a loss of $100. This example demonstrates the impact of the spread on an ETF investment. ETFs that are more liquid and have higher trading volume have tighter or smaller spreads. The spread can be thought of as a hidden cost to investors since spreads reduce potential returns.
Changes in discounts and premiums to NAV. For a variety of reasons, an ETF’s market price may reflect a premium or a discount to the ETF’s underlying value or NAV. This is a potential cost but also a potential gain. An ETF share is trading at a premium when its market price is higher than the NAV or the value of its underlying holdings. An ETF share is trading at a discount when its market price is lower than the NAV or value of its underlying holdings. An investor may, therefore, pay more or less than the NAV when buying shares or receive more or less than NAV when selling shares.
Management Fees are fees paid out of a mutual fund or ETF’s assets to the fund’s investment adviser for investment portfolio management. They can also include any other management fees payable to the fund’s investment adviser or its affiliates and administrative fees payable to the investment adviser.
Distribution and/or Service Fees are fees paid out of the mutual fund or ETF assets to cover the costs of distribution (e.g., marketing and selling fund shares) 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. Shareholder Service Fees are fees paid to persons to respond to investor inquiries and provide investors with information about their investments.
Other Expenses are fees paid out of mutual fund or ETF assets that are not already included under Management Fees or Distribution or Service (12b-1) Fees (such as any shareholder service expenses that are not already included in the 12b-1 fees), custodial expenses, legal and account expenses, transfer agent expenses and other administrative expenses.
Total Annual Fund Operating Expenses (Expense Ratio). This line of the fee table that represents the total of a mutual fund’s or ETF’s annual fund operating expenses expressed as a percentage of the fund’s average net assets. Looking at the expense ratio can help investors make comparisons among various mutual funds and ETFs.
Caveat: Fund Fees
Investors should be sure to review carefully the fee tables of any mutual funds or ETFs they are considering, including no-load mutual funds. Even small differences in fees can translate into large differences in returns over time. For example, if an investor invested $10,000 in a fund that produced a 5% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years the investor could have roughly $19,612. However, if the fund had expenses of only 0.5%, then the investor would end up with $24,002—a 23% difference.