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Beware of Mutual Fund Fees: 3 Keys to Consider

Mutual funds are the smartphones of investing. Think about it, rather than carrying a cell phone, laptop, camera and iPod, it’s all right there in one convenient device. Mutual funds combine hundreds of stocks or bonds in one convenient investment package.

And like smartphones, you’ve got to watch out for hidden charges — but instead of data, text, activation and overage fees, you’ll be looking for sales charges, expense ratios, trading costs and investment style.

Lets take a look at each one:

Sales Charges

Where you buy your mutual fund makes a difference. Whether through a financial advisor, discount broker or directly through a mutual fund company, you will want to be aware of potential sales charges:

• Front-loaded mutual funds. Brokers call these “A” share mutual funds. The sales commission is typically 5% but can be as high as 8.5%. It’s paid up front and immediately reduces your total initial investment.
• Level-loaded mutual funds. These “class C” funds charge a typical 1% annual fee — forever.
• Back-loaded funds. Also known as “contingent deferred sales charges” these funds charge a fee only if you sell out of your investment. The charge decreases from year to year, usually beginning in year one around 5%.
• No-load funds. Mutual funds that don’t have a sales charges. But that doesn’t mean there are no fees at all. You’ll see what we mean as you read on.

Expense Ratios

Since mutual funds are managing a portfolio of stocks and bonds for you, somebody has to get paid for doing their job, right? These “management” fees are part of the invisible net of hidden fees that drag down the performance of your investments. And there are a lot of them.

Among these hidden fees are distribution and marketing (12b-1 ) fees. Simply stated: commissions and marketing expenses. There can also be “shareholder” service fees, custodial charges, legal and accounting fees and transfer and administrative charges.

Redemption fees can also be charged when you sell shares of a mutual fund. They are an attempt to discourage active traders from moving in and out of mutual funds.

All of these charges are totaled up and divided into the average dollar value of all of the investments managed by the fund, creating an expense ratio. You’ll find this tally listed in fund prospectuses as well as on mutual fund profiles. It’s easy to make use of this handy ratio: generally the lower, the better.

Here’s a NerdWallet Inside Tip:

Some hidden charges aren’t revealed in the expense ratio but are important to consider: trading and transaction costs. All of those stocks and bonds being bought and sold inside your mutual fund are incurring trading commissions and other costs. Recent studies estimate these trading expenses can total up to 1-3% of assets under management.

Not all of these charges are revealed by mutual fund companies, so look for the “turnover” statistic on a mutual fund profile. The more turnover, the more trading that is occurring – and the more the transaction expenses are adding up. An annual turnover of 100% or more can mean trading costs could be an important factor to consider.

Active versus Passive Investing

The debate has long been held: are “active” mutual funds worth the additional expense over “passive” funds?

Active funds look to outperform an index, while passive funds simply attempt to duplicate the returns of a market. Time and time again this “argument” has been settled: independent study after study has revealed that the majority of active mutual funds fail to beat the market. NerdWallet has crunched the numbers and the result is still the same.

And yet investors still search for a “secret sauce” or unfair advantage, paying a higher cost for poorer results. The best strategy is to seek out a source offering a wide variety of low-cost mutual funds and consider passive “index” strategies over active managers.

Written by Hal M. Bundrick

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