Understanding the True Cost of Mutual Fund Ownership

Let me ask you this: How much does it cost to own a mutual fund? I’ll give you hint: It’s safe to say probably more than you think…

Did you answer “1% to 1.5%”? When discussing mutual fund expenses, too often professionals and laypeople alike resort to rules of thumb like “1% – 1.5%.”  This rule of thumb is seriously flawed, and it could actually be costing you a lot more money!

There are four major costs of mutual fund ownership:

• Annual money management expenses,
• Trading costs,
• Sales Commissions or contingent deferred sales charges, and
• Annual income taxes.

Mutual Fund Annual Expenses

Where did the “1% to 1.5%” rule of thumb come from? It is around the average annual expense charged by mutual fund companies. This includes payment for the fund managers, payment for the financial professional who sold the fund (known as 12b-1 fees), as well as administrative fees, marketing expenses, and other costs associated with running a mutual fund company. Keep in mind the actual expense may be higher or lower depending on the fund.

Trading Costs

Just like any individual investor has to pay a brokerage commission or ticket charge to place trades, so does a mutual fund company. The mutual fund company’s advantage is that they receive volume discounts that individual investors would rarely, if ever, receive. However, these commissions are paid and passed on in full to fund owners in the form of a reduction in the return a mutual fund owner receives on their fund. Worse yet, this cost is not typically disclosed in the fund prospectus, and is usually only found in a fund’s supplemental prospectus, or statement of additional information (SAI). These trading costs are estimated to reduce a mutual fund’s annual gain by 0.5% to 1% per year.¹

Sales Commissions, Loads, and Contingent Deferred Sales Charges

There are 4 basic ways investors pay commissions to purchase mutual funds:

1. Up-front, out-of-pocket commission around 5%, commonly called A-share load, or front-load. This equates to your $1,000 investment being immediately reduced to $950.
2. Increased annual expense of owning the fund, and a declining contingent deferred sales charge which is assessed if a mutual fund is sold in certain period of time, usually averaging 7 years, also known as B-share.
3. Increased 12b-1 fee in lieu of an up-front load or contingent charge, as is the case with C-share funds.
4. An annual money management fee of 0.5% to 2.0% paid to a fee-only adviser.

For our discussion, it is less important to dig into each and every fee structure, and more important to understand that some fee is being charged and it affects the owner’s overall return. Assuming the average mutual fund is held for 3.3 years², whether you pay up-front, over-time, or upon-sale really doesn’t matter—it will average about 1% per year.

Annual Income Taxes

According to Lipper, Inc. the federal income taxes, on average, reduce mutual fund net gains by 20%, resulting in an average annual loss of 1.13% to 2.13%.³ Add to that state and local taxes and your gains could be reduced even more. There are sometimes gains embedded in the funds that the fund owner will have to pay taxes on, known as a taxable distribution, regardless of when they actually purchased the fund.⁴ (Taxation is not an issue for mutual funds held in a tax-qualified retirement account, such as an IRA or 401(k), nor for funds held in state-sponsored 529 plan.)

So, let me ask you again: “How much does it cost to own a mutual fund?”  Without knowing your exact portfolio, my safe answer is now “probably more than you thought.”

Drew Powers is an Investment Advisor Representative with AOS, Inc., which does business as TradingBlock and MoneyBlock, a registered Broker-Dealer, FINRA, NFA and SIPC member, and a Registered Investment Adviser.

1.  The Great Mutual Fund Trap, Baer & Gensler, p. 104
2. 2013 Quantitative Analysis of Investor Behavior, Dalbar, Inc., 2013
3. “Taxes in the Mutual Fund Industry – 2009 – Assessing the Impact of Taxes on Shareholders’ Returns, Lipper, Inc., April 2009 [accessed via: http://www.investmentnews.com/assets/docs/CI60985417.PDF ]
4. “U.S. mutual funds hit investors with big capital gains,” Reuters, December 11, 2013 http://www.reuters.com/article/2013/12/11/funds-investors-gains-idUSL1N0JQ1DU20131211