Mutual fund fees fall into two general categories: loads and operating expenses.
Fees and expenses are important because they reduce the total return that you, the investor, make on your mutual fund investment.
For example, if one fund has an annual expense ratio of 3 percent, it would have to post a return that was at least two percentage points higher than a fund with a 1 percent expense ratio to match the return to the investor.
OPERATING EXPENSES
Operating expenses are all the administrative, management, distribution and other costs that a fund company incurs in running a mutual fund.
They are expressed as the “annual expense ratio” of the fund, a percentage figure which can be found on fund prospectuses as well as the fund profiles on CBS MarketWatch. The largest portion of a fund’s operating expenses is the management fee, which a fund pays to the managers of the fund.
12B-1 FEE
Named for a rule in the Investment Company Act of 1940, a 12b-1 fee is charged by some mutual funds to cover marketing and distribution expenses, such as paying sales professionals. By law, this fee cannot exceed 0.75 percent of a fund’s average net assets per year, and funds are required to disclose the fee in prospectuses.
A no-load fund can charge a 12b-1 fee of up to 0.25 percent of assets. A fund’s annual expense ratio includes 12b-1 fees.
LOADS
Loads, also called “shareholder fees,” are separate from operating expenses and aren't included in the annual expense ratio. Loads are sales charges usually designed to compensate a financial professional such as a broker for his or her services in selling the fund – and in helping you select it.
The most common type of load is the “front-end load,” a one-time fee charged at the time of purchase. These fees can range as high as 8.5 percent, but funds that use them usually charge anywhere from 3 percent to 6 percent. A “back-end load,” also called a “deferred sales charge,” is levied when an investor sells his or her shares. Some funds only charge back-end loads if an investor redeems the shares before a certain period of time, for example one year.
CLASSES OF SHARES
Some funds offer different share classes, which basically represent different ways of charging investors for the same mutual fund. While these classes differ from fund to fund, Class A shares usually have a front-end load; Class B shares often have a 12b-1 fee and a back-end load, and Class C shares often have a higher 12b-1 fee (and thus a higher expense ratio) but no load.
Taxes
Mutual fund investors are taxed on their investments in three ways – the sale of shares, capital-gains distributions and dividend distributions.
When you sell your shares, you must pay capital-gains taxes on any profit that you made. Likewise, you can declare a loss on the investment if the shares decreased in value. The amount of gain or loss is determined by the difference between the sale price and the “cost basis” of the fund shares (generally the purchase price).
DISTRIBUTIONS
Mutual fund investors are also taxed on the two types of distributions that mutual funds make to shareholders during the year – dividends and capital gains.
Dividend distributions are primarily from the interest and dividends earned from the investments in the fund’s portfolio. These must be reported as income on your 1040 federal tax form.
Capital-gains distributions represent any gains from the sale of shares held more than a year that the fund itself made during the year. These are taxed as capital gains, often at lower rates than federal income taxes.
Fund investors are often befuddled by a large drop in the share price of their fund when distributions are paid out. In such cases, while the share price may have dropped sharply, the number of shares in the fund -- and the number of shares you own – increased proportionately, meaning the value of your investment stayed the same.
TAX EFFICIENCY
Most mutual fund investors mistakenly overlook the issue of tax efficiency when purchasing mutual funds, and yet it can have as large an impact on your total return as the fund’s expenses or even its performance.
The factor which most drives the tax efficiency of any given fund is its turnover ratio – how often the investments within the portfolio are bought and sold during the year. Funds looking for conservative, steady long-term returns are likely to have lower turnover ratios – and as a result higher tax efficiency – than aggressive funds looking for sharp short-term gains. Funds usually report their tax efficiency ratios on their prospectuses, and some fund companies have begun to report after-tax returns on their Web sites.
Keep in mind that, if you hold your funds in a 401(k) or other tax-deferred retirement account, the issue of tax efficiency is mostly moot, as dividends and capital gains accrue tax-deferred until you draw from the account.
