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Understanding your mutual fund costs begins with understanding the underlying mechanics of your investment.  In almost all circumstances, you own individual companies, loans (bonds) made to individuals, business and governments, and sometimes a few alternative securities types such as an option or commodity.  These investments compensate you for your ownership (indirectly through the fund) and can increase or decrease in value over time.  For discussion’s sake, let’s assume these investments increased 10% over the last year.

When you own a mutual fund, you don’t own these investments directly.  Instead, you indirectly share in the ownership of these investments, mutually, with many other people.  Your mutual fund manager decides when to buy and sell these investments and is responsible for ensuring there is enough liquidity available to provide cash to people who need to sell shares.  The Fund also reports its taxable gains and losses to you as the fund’s owner (a potential impact of about 1.1% according to Morningstar[1]).  Let’s take a deeper look.

The Obvious Expenses

Let’s say you own the fictitious Basic Blue-Chip Fund.  The fund’s manager is responsible for the selection of the investments you own vicariously through the fund.  The manager and staff need to feed their families, so they charge an annual fee to each person who owns the fund: the expense ratio.  The expense ratio is an annual fee disclosed clearly in the prospectus and appears on most materials presenting the fund.  Several academic studies have been published in recent years finding the average expense ratio is between 0.90% and 1.19%.[2] Let’s call it an even 1% for ease of conversation.  The fund company also clearly discloses distribution fees, called 12b-1 fees, which generally range between 0.00% and 0.75%.  If you’re paying a 0% 12b-1 fee, most of the time, you make up for the discounted cost in another method, such as a fee-based account, a retirement plan advisory fee, or in transaction fees if you DIY.

Other Costs

The manager must now run the business of investing the money you entrusted to the fund, the costs of which don’t show up in your expense ratio.  The management team calls upon their colleagues around the industry for help.  They ask the financial firm “Bond Co.” to research the government bonds they should use in the fund.  In return, they pay Bond Co. a commission when they purchase the bonds.  In many cases, they also ask Bond Co. to house the bonds for them at their firm using what is called an omnibus account, a service for which they will pay an additional fee.  These are disclosed (generally in dollar values) in a document called the Statement of Additional Information which is available on request from the fund.  Funds also experience a phenomenon called “price impact” when they engage in these transactions (which is a little more technical than we want to get in this article).  These costs average approximately 1.44%.[3]

What does Mutual Fund ACTUALLY Cost?

SO if you have the basket of investments that earned 10%, and you own them in the form of a mutual fund,

The assets earn 10% in the fund
The Fund pays its management team about 1%
The fund pays its distributors .75%
The Fund experiences 1.44% of internal costs relating to the acquisition and disposition of the assets

So in total, you actually experience a cost of 3.19%.  You don’t see this on a bill, but instead it shows up as a reduction in the Mutual Fund’s return so you would see a return on your statement of 6.81% instead of the original 10%.

We don’t believe that these fees and costs are necessarily a bad thing; In fact, recent data published by George Mason University suggests that, on average, a 0.02% increase in expense ratio provides an average increase in performance of 0.13%.[4]  But we do think it’s important to understand your fee structure so you can make the most informed decisions possible.

[1] http://news.morningstar.com/articlenet/article.aspx?id=373782More recent studies by Morningstar show that fees have declined on average since the 2011 study, showing an arithmetic average of 1.10%.  The decline of geometric average is primarily attributed to the increased popularity of passive mutual funds which generally have expense ratios of about 20bps.

[2] Cf. Kinnel, Russel. “Mutual Fund Expense Ratios See Biggest Spike Since 2000.” 19 April 2010. Morningstar Advisor. 31 January 2011.; Edelen, Rodger, Evans, Richard, Kadelec, Gregory.  “Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance”  Financial Analysts Journal Vol 69 No. 1. ©2013.

[3] Edelen, Rodger, Evans, Richard, Kadelec, Gregory.  “Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance”  Financial Analysts Journal Vol 69 No. 1. ©2013.

[4] Horan, Stephen M and D. Bruce Johnsen. “Does Soft Dollar Brokerage Benefit Portfolio Investors: Agency Problem or Solution?” George Mason University School of Law (2004): 4