Fund Expense - Ongoing hidden fees paid to your fund management company
The ultimate cost of owning a mutual fund is far greater than what meets the eye. Only part of the total cost is reported by the expense ratio. Other hidden fees can be much more than this explicit expense.
The expense ratio is frequently the only cost that many investors believe they pay when owning a mutual fund. That is wrong! The total cost of owning a fund is far greater than the expense ratio only. This is primarily due to two reasons. First, only about a fraction of the total cost is reported by the expense ratio. Other hidden fees can more than triple this explicit expense. Another factor often missed is the power of compounding fees, and even small changes in expense can become material over time.
Expense ratio
The expense ratio of a mutual fund is frequently used to pay marketing costs, distribution costs and management fees. This cost can be very different for the same mutual fund when some mutual funds offer investors different types of shares, known as "classes". A commission-based advisor normally only sell Class A (front-load or front-commission), Class B (back-load or back-commission), and Class C (higher expense or ongoing commission).
Unfortunately, some investors were misled by their commission-based advisor to falsely believe these higher expense classes of the fund are better. Actually, each class will invest in the same "pool" (or investment portfolio) of securities and will have the same investment objectives and policies. The only difference is that each class has its specified marketing and sales commission arrangements and, therefore, different performance results.
Loads (commissions) can also cause investors to feel trapped in an investment. If you buy a load fund and want to sell it, the broker may want to sell you another load fund, which means you'll have to pay another commission. Instead of selling it, you might stick with the fund longer than you should. Or you could stay within the same fund family to avoid paying another load, but that limits your choices and chances for finding the best fund.
In the 1920s, when the first mutual funds were launched, the only funds available were load funds, so investors had no other option. Now there are plenty of great funds that don't charge a load. There is no reason to buy a Class A (unless you do not pay a load), Class B, or Class C mutual fund because the extra loads and commissions will always reduce your investment return as compared to a better no-load fund alternative.
12b-1 fee
Most funds also have 12b-1 fee on top of annual management expense. No-load funds can charge 12b-1 fee as well. They are paid from the fund assets to cover distribution expenses and sometimes shareholder service expenses. These fees pay for marketing and selling fund shares, such as compensating broker dealers to sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. Under FINRA rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75% of a fund’s average net assets per year.
Transaction cost
Recent research found U.S. stock mutual funds have an average transaction cost of over 1 percent per year, which is not included in the expense ratio. These fees are not found in most prospectuses and can be difficult to determine. The first part of these fees is the commission paid to the broker. This alone costs investors roughly 0.25% each year. When a portfolio manager decides to trade a position, the large volume is enough to influence the market price. Before the entire order can be sold, the heavy volume drives down the price and a portion of the shares are sold at the lower price, or vice versa for a purchase order. This negative impact costs investors 0.5% - 1% easily.
Tax cost
Investors with taxable accounts end up paying more than their share when investing in mutual funds. It is estimated that these cost investors an additional 1% per year (for equity funds). Dollars typically flock to funds with the best performance. In order to build a favorable track record, the manager must have investments that increase in value, and thus have accumulated unrealized gains. When these gains are realized by selling the investment, owners of the fund must pay capital gains taxes, known as capital gain distribution each year in December. Unfortunately, this applies to the total gain realized by the fund, even if the investor entered only short-term after the stocks appreciated.
Expense ratio
The expense ratio of a mutual fund is frequently used to pay marketing costs, distribution costs and management fees. This cost can be very different for the same mutual fund when some mutual funds offer investors different types of shares, known as "classes". A commission-based advisor normally only sell Class A (front-load or front-commission), Class B (back-load or back-commission), and Class C (higher expense or ongoing commission).
Unfortunately, some investors were misled by their commission-based advisor to falsely believe these higher expense classes of the fund are better. Actually, each class will invest in the same "pool" (or investment portfolio) of securities and will have the same investment objectives and policies. The only difference is that each class has its specified marketing and sales commission arrangements and, therefore, different performance results.
Loads (commissions) can also cause investors to feel trapped in an investment. If you buy a load fund and want to sell it, the broker may want to sell you another load fund, which means you'll have to pay another commission. Instead of selling it, you might stick with the fund longer than you should. Or you could stay within the same fund family to avoid paying another load, but that limits your choices and chances for finding the best fund.
In the 1920s, when the first mutual funds were launched, the only funds available were load funds, so investors had no other option. Now there are plenty of great funds that don't charge a load. There is no reason to buy a Class A (unless you do not pay a load), Class B, or Class C mutual fund because the extra loads and commissions will always reduce your investment return as compared to a better no-load fund alternative.
12b-1 fee
Most funds also have 12b-1 fee on top of annual management expense. No-load funds can charge 12b-1 fee as well. They are paid from the fund assets to cover distribution expenses and sometimes shareholder service expenses. These fees pay for marketing and selling fund shares, such as compensating broker dealers to sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. Under FINRA rules, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75% of a fund’s average net assets per year.
Transaction cost
Recent research found U.S. stock mutual funds have an average transaction cost of over 1 percent per year, which is not included in the expense ratio. These fees are not found in most prospectuses and can be difficult to determine. The first part of these fees is the commission paid to the broker. This alone costs investors roughly 0.25% each year. When a portfolio manager decides to trade a position, the large volume is enough to influence the market price. Before the entire order can be sold, the heavy volume drives down the price and a portion of the shares are sold at the lower price, or vice versa for a purchase order. This negative impact costs investors 0.5% - 1% easily.
Tax cost
Investors with taxable accounts end up paying more than their share when investing in mutual funds. It is estimated that these cost investors an additional 1% per year (for equity funds). Dollars typically flock to funds with the best performance. In order to build a favorable track record, the manager must have investments that increase in value, and thus have accumulated unrealized gains. When these gains are realized by selling the investment, owners of the fund must pay capital gains taxes, known as capital gain distribution each year in December. Unfortunately, this applies to the total gain realized by the fund, even if the investor entered only short-term after the stocks appreciated.
Investor Alerts on Mutual Fund Expense:
- Many fee-only or fee-based advisors will manage an investor’s portfolio for an annual fee roughly 1% of the portfolio’s balance. This fee is required to be disclosed on investors’ statements. Investors must be aware that the advisor's fee is charged in addition to the other mutual fund costs discussed above. The final cost is up to the advisors who select mutual funds or use other lower cost alternatives (ETFs and stocks) for their clients.
- Some investors were brainwashed to believe that a load fund has a much better performance record than a no-load fund. If you meet a knowledgeable advisor with your best interest first, the advisor should be able to easily find a similar no-load fund that performs just as well or better.
- While some things are worth paying more for, loads and higher-expense Class C shares are completely unnecessary when it comes to buying a mutual fund. Individual investors should focus on finding the best no-load funds.
Closed-end funds without using leverage have expenses likely to be on par with those of similar open-end mutual funds, but the adjusted expense ratios of leveraged closed-end funds are almost always higher.
A closed-end fund (CEF) is a type of investment company that pools money from investors to buy securities. Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange.
Because closed-end funds trade like stocks, the supply and demand for the shares determines their market price. Both closed-end funds and mutual funds have an inherent net asset value (NAV) that reflects the value of the funds' underlying assets (less liabilities) divided by the number of shares outstanding. Closed-end funds have historically traded at a discount to NAV, that is, at a market price lower than the fund's NAV. In contrast, shares of a mutual fund are always priced based on the NAV, which is set daily at the close of trading.
Like other fund vehicles, management fees constitute the part of CEF expenses, along with a host of other miscellaneous fees (trading cost, exchange listing fees, legal fees, audit fees, board of directors' fees, and so on). After accounting for fund size, CEF fees tend to be on par with those charged by similar actively managed open-end funds. Expenses are simple for CEFs that don't use leverage. Unfortunately, accounting for leverage is not straightforward. Leverage is not free. Fund companies attempt to break down expenses by publishing two numbers, a total expense ratio and an adjusted expense ratio. The former is meant to include the costs associated with leverage, while the latter is meant to exclude leverage costs.
Debt cost and risks
Many CEFs borrow money to buy securities. The average CEF has almost 33% in leverage. That can boost yield by adding to the number of holdings in a CEF that are paying dividends, interest or capital-gain income. But it can also magnify losses. If interest rates rise, longer-term bonds and additional rate-sensitive securities will likely lose value. The relative cost of a CEF's debt would rise.
Distribution cost
A CEF's income can be very tricky. Do not be fooled by high income which is not necessarily earned dividend, rather it is called distribution. The distribution income of many CEFs consists of return of principal. It is not from earnings. A CEF with a defined constant distribution policy must return principal if it is unable to meet periodic distribution levels that shareholders have come to expect. Depleting capital can erode the CEF's share price over time.
Because closed-end funds trade like stocks, the supply and demand for the shares determines their market price. Both closed-end funds and mutual funds have an inherent net asset value (NAV) that reflects the value of the funds' underlying assets (less liabilities) divided by the number of shares outstanding. Closed-end funds have historically traded at a discount to NAV, that is, at a market price lower than the fund's NAV. In contrast, shares of a mutual fund are always priced based on the NAV, which is set daily at the close of trading.
Like other fund vehicles, management fees constitute the part of CEF expenses, along with a host of other miscellaneous fees (trading cost, exchange listing fees, legal fees, audit fees, board of directors' fees, and so on). After accounting for fund size, CEF fees tend to be on par with those charged by similar actively managed open-end funds. Expenses are simple for CEFs that don't use leverage. Unfortunately, accounting for leverage is not straightforward. Leverage is not free. Fund companies attempt to break down expenses by publishing two numbers, a total expense ratio and an adjusted expense ratio. The former is meant to include the costs associated with leverage, while the latter is meant to exclude leverage costs.
Debt cost and risks
Many CEFs borrow money to buy securities. The average CEF has almost 33% in leverage. That can boost yield by adding to the number of holdings in a CEF that are paying dividends, interest or capital-gain income. But it can also magnify losses. If interest rates rise, longer-term bonds and additional rate-sensitive securities will likely lose value. The relative cost of a CEF's debt would rise.
Distribution cost
A CEF's income can be very tricky. Do not be fooled by high income which is not necessarily earned dividend, rather it is called distribution. The distribution income of many CEFs consists of return of principal. It is not from earnings. A CEF with a defined constant distribution policy must return principal if it is unable to meet periodic distribution levels that shareholders have come to expect. Depleting capital can erode the CEF's share price over time.
Investor Alerts on Closed-End Fund Expense:
- Many closed-end funds are initially sold to investors through commission-based advisors. Typically, the IPO price may include a "built-in" sales charge of up to 5 percent of the price that goes to the broker who sells you the shares, plus a separate amount for the offering expenses. Investors are often better off to buy closed-end funds after IPO because most Closed-end funds have historically traded at a discount.
- Closed-end funds typically pay distributions to investors on a monthly or quarterly basis. In some cases, distributions also include a return of principal. That means the monies used to pay the distribution come from the fund's assets rather than from any income generated by the investments in the fund's portfolio. Closed-end funds that return capital can carry a higher level of risk because the fund is eroding the asset base which often leads to the ultimate winding down completely. Before you invest in a fund, find out if the closed-end fund follows this flawed approach, also known as a managed distribution policy.
Total fees of owning ETFs are generally lower than mutual fund expenses except they can incur cost related to transaction, spread, and tracking error.
Exchange traded funds (ETFs) can be a great investment vehicle for small and large investors alike. These popular funds, which are similar to mutual funds but trade like stocks, have become a increasingly popular choice. ETFs and comparable index-based mutual funds have a lot in common. Both invest in hundreds or thousands of stocks, bonds, and other securities, permitting investors to obtain broad diversification through their purchase. Both are professionally managed to passively track a predefined index. There are also some meaningful differences. ETFs are traded on the major stock exchanges. The price of an ETF fluctuates during the course of a day. Mutual funds, including index funds, are priced once a day at the close of the market.
Transaction fee
To purchase or sell an ETF, you need to open a brokerage account. Index funds can typically be purchased directly from the fund family. Transaction costs are higher for ETFs than for index funds. You may have to pay a commission. Buying an ETF with a lump sum is simple. Say $10,000 is what you want to invest in a particular ETF. You calculate how many shares you can buy and what the cost of the commission will be and you get a certain number of shares for your money. However, ETFs can be more costly to trade for small investors building a position through dollar-cost averaging.
Tracking error cost
Unlike mutual funds, premiums or discounts to net asset value (NAV) may occur when investors bid the market price of an ETF above or below the NAV of its basket of securities. In the case of a premium, the authorized participant (known as market maker) typically arbitrages it away by purchasing securities in the ETF basket, exchanging them for ETF units and selling the units on the stock market to earn a profit (until the premium is gone). And vice versa if a discount exists. Such divergences are usually rare but can be over 1% for those thinly traded ETFs.
Liquidity and spread cost
The biggest factor in any ETF or stock or anything that is traded publicly is liquidity. Liquidity means that when you buy something, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price. If an ETF is thinly traded, there can be problems getting out of the investment, depending on the size of your position in relation to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and ask. With so many new ETFs coming to market, you need to make sure that the ETF is liquid. The best way to do this is to study the spreads and the market movements over a week or month.
Capital gains distribution
Similar to many equity mutual funds, some ETFs will distribute capital gains to shareholders. This is not always desirable for ETF holders, as shareholders are responsible to pay the capital gains tax. It is usually better that the fund retains the capital gains and invests them, rather than distributing them and creating a tax liability for the investor. Investors will usually want to re-invest those capital gains distributions and, in order to do this, they will need to go back to their brokers to buy more shares, which creates new fees.
Transaction fee
To purchase or sell an ETF, you need to open a brokerage account. Index funds can typically be purchased directly from the fund family. Transaction costs are higher for ETFs than for index funds. You may have to pay a commission. Buying an ETF with a lump sum is simple. Say $10,000 is what you want to invest in a particular ETF. You calculate how many shares you can buy and what the cost of the commission will be and you get a certain number of shares for your money. However, ETFs can be more costly to trade for small investors building a position through dollar-cost averaging.
Tracking error cost
Unlike mutual funds, premiums or discounts to net asset value (NAV) may occur when investors bid the market price of an ETF above or below the NAV of its basket of securities. In the case of a premium, the authorized participant (known as market maker) typically arbitrages it away by purchasing securities in the ETF basket, exchanging them for ETF units and selling the units on the stock market to earn a profit (until the premium is gone). And vice versa if a discount exists. Such divergences are usually rare but can be over 1% for those thinly traded ETFs.
Liquidity and spread cost
The biggest factor in any ETF or stock or anything that is traded publicly is liquidity. Liquidity means that when you buy something, there is enough trading interest that you will be able to get out of it relatively quickly without moving the price. If an ETF is thinly traded, there can be problems getting out of the investment, depending on the size of your position in relation to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and ask. With so many new ETFs coming to market, you need to make sure that the ETF is liquid. The best way to do this is to study the spreads and the market movements over a week or month.
Capital gains distribution
Similar to many equity mutual funds, some ETFs will distribute capital gains to shareholders. This is not always desirable for ETF holders, as shareholders are responsible to pay the capital gains tax. It is usually better that the fund retains the capital gains and invests them, rather than distributing them and creating a tax liability for the investor. Investors will usually want to re-invest those capital gains distributions and, in order to do this, they will need to go back to their brokers to buy more shares, which creates new fees.
Investor Alerts on ETF Fee:
- ETFs track indexes and when the indexes are updated, the ETFs have to follow suit. Updating the ETF portfolio incurs transactions costs. And it may not always be possible to do it the same way as the index. For example, a stock added to the ETF may be at a different price than what the index maker selected.
- Be very careful when buying commodity ETFs which track the price of a commodity through the futures markets. As the weeks pass and the contract nears expiration, the ETF provider will sell it (to avoid taking delivery) and buy the next month's contract. This operation, known as the "roll," is repeated every month. If contracts further from expiration have higher prices (known as "contango"), the roll into the next month will be at a higher price, which incurs a loss. Thus, even if the spot price of the commodity stays the same or rises slightly, the ETF could still show a decline.
In addition to the high upfront fees, non-traded REITs may have significant transaction costs, such as property acquisition fees and asset management fees.
Private placement offerings allow companies to raise money by selling stocks, bonds and other instruments. Such offerings may be exempt from federal securities registration requirements. This exemption allows a company to raise business capital without having to comply with the registration requirements of a public securities offering. One most common example many investors may be interested is private high-dividend real estate investment trust (REIT). Such non-traded REITs are registered with the SEC, file regular reports with the SEC, but are not listed on an exchange and are not publicly traded. An investment in a non-traded REIT poses risks different than an investment in a publicly traded REIT.
High fee
Non-traded REITs typically charge high upfront fees to compensate a firm or individual selling the investment and to lower their offering and organizational costs. These fees can represent up to 15 percent of the offering price, which lowers the value and return of your investment and leaves less money for the REIT to invest. In addition to the high upfront fees, non-traded REITs may have significant transaction costs, such as property acquisition fees and asset management fees.
Lack of share value transparency
Because non-traded REITs are not publicly traded, there is no market price readily available. Consequently, it can be difficult to determine the value of a share of a non-traded REIT or the performance of your investment. In addition, any share valuation will be based on periodic or annual appraisals of the properties owned by the non-traded REIT, and therefore may not be accurate or timely. As a result, you may not be able to assess the value or performance of your non-traded REIT investment for significant time periods.
Liquidity cost
Non-traded REITs are illiquid investments, which mean that they cannot be sold readily in the market. Instead, investors generally must wait until the non-traded REIT lists its shares on an exchange or liquidates its assets to achieve liquidity. These liquidity events, however, might not occur until more than 10 years after your investment. Non-traded REITs usually offer investors’ opportunities to redeem their shares early but these share redemption programs are typically subject to significant limitations and may be discontinued at the discretion of the REIT without notice. Redemption programs also may require that shares be redeemed at a discount, meaning investors lose part of their investment if they redeem their shares.
High fee
Non-traded REITs typically charge high upfront fees to compensate a firm or individual selling the investment and to lower their offering and organizational costs. These fees can represent up to 15 percent of the offering price, which lowers the value and return of your investment and leaves less money for the REIT to invest. In addition to the high upfront fees, non-traded REITs may have significant transaction costs, such as property acquisition fees and asset management fees.
Lack of share value transparency
Because non-traded REITs are not publicly traded, there is no market price readily available. Consequently, it can be difficult to determine the value of a share of a non-traded REIT or the performance of your investment. In addition, any share valuation will be based on periodic or annual appraisals of the properties owned by the non-traded REIT, and therefore may not be accurate or timely. As a result, you may not be able to assess the value or performance of your non-traded REIT investment for significant time periods.
Liquidity cost
Non-traded REITs are illiquid investments, which mean that they cannot be sold readily in the market. Instead, investors generally must wait until the non-traded REIT lists its shares on an exchange or liquidates its assets to achieve liquidity. These liquidity events, however, might not occur until more than 10 years after your investment. Non-traded REITs usually offer investors’ opportunities to redeem their shares early but these share redemption programs are typically subject to significant limitations and may be discontinued at the discretion of the REIT without notice. Redemption programs also may require that shares be redeemed at a discount, meaning investors lose part of their investment if they redeem their shares.
Investor Alerts on Non-Traded REIT Fee:
- When working with a broker or an investment adviser to buy a non-traded REIT, it is important to check that they are registered with the SEC or a state securities regulator. If the person is not registered, it could be a red flag for fraud. You can find out if someone is registered and obtain information about the person by visiting the SEC’s Investment Adviser Public Disclosure (IAPD) website or FINRA’s BrokerCheck website. You can also check with your state securities regulator about the person soliciting your investment.
- Investors may be attracted to non-traded REITs by their high distributions, which may be referred to as dividend yields, compared to other investment options, including publicly traded REITs. However, the initial distributions may not represent earnings from operations since non-traded REITs often declare these distributions prior to acquiring significant assets. Investors of non-traded REITs must avoid focusing exclusively on the high distributions. Non-traded REITs may use offering proceeds, which includes the money you invested, and borrowings to pay distributions. This practice reduces the value of the shares and reduces the cash available to the REIT to purchase real estate assets.