Posted on October 1, 2014 in ,

The Hidden Costs of Mutual Funds

Excerpts Published Thursday, September 25, 2014 by Lakeland Ledger

Academic studies have proven that investors in mutual funds generally underperform the market for a few reasons: high fees and market timing.  Today’s discussion is about high fees.  A more disastrous discovery about high fees is that some companies in the mutual fund industry are very adept at hiding most of the added costs to investors through layers of complex formulas which are built into the security’s net asset value (NAV). So what is the average investor to do?


As discussed in my recent article, Beating the Market Index, high fees is the primary enemy of mutual fund investors.  Knowing what to avoid will minimize these costs and will only help you achieve the types of returns you should expect in your portfolio.

Class A share mutual funds are sold from brokerage houses that take a front-end fee before the investment begins.  The front-end fee, or load, is a commission paid for the expertise of the broker that chose the fund for you.  For investors with a shorter time horizon, these loads are detrimental to their returns as the loss of principal may never be recovered during the holding period of the fund.  Class A shares commonly charge 5.75% to purchase these funds, although by law, the highest load can be up to 8.5%.  The load is not paid directly by the investor, but rather it reduces the amount of the initial investment.

Class B shares usually have back-end loads that are charged upon a sale of the fund.  The longer the holding period, the lower the commission you will be charged.  Class B share mutual funds have a higher annual expense ratio (management fee) to offset the potential loss of the commission to the broker who may never recoup the lost fee if shares are held longer than the redemption period.

Class C shares often have a high level-load (imposed annually) together with a high expense ratio.  Similar to B shares, they often levy back-end loads.  This class of fund is sold to the investor with a very short time horizon.  The longer the Class C funds are held, the lower the performance due to the high annual costs.

Hidden level-loads, or 12b-1 fees, are an annual cost some funds charge to offset the broker’s marketing and advertising expenses.  According to a 2010 article in The Wall Street Journal, these 12b-1 fees totaled $9.5 billion annually.  These fees sometimes result in private commissions or soft dollars to brokers, and often pay for fishing trips or vacation incentives provided by the broker’s firm for selling their mutual fund.  Mutual funds and their fees are regulated by the Securities & Exchange Commission, and there is pressure on the industry to lower their expenses.


With all of the fees associated with mutual funds, you may think that you should stick to individual stocks and bonds, CD’s, and money market funds.  Mutual funds were created to provide diversification and professional management.  I often tell my clients that we only recommend mutual funds with very low costs, especially ones with no loads and no 12b-1 fees.  Academic research has proven time and time again that fees directly impact total return. Low cost alternatives, including passive index funds, are available to investors.  The three top companies in the industry with lower costs are Fidelity Investments, Vanguard, and iShares.

Do your research to screen for funds with the lowest fees and highest returns over 10 or more years.  Continue to read a fund’s prospectus if changes occur to ensure your portfolio isn’t paying more fees than necessary.  If you don’t have the time to perform the proper research, have an independent advisor do it for you.

Source: The Wall Street Journal