In a recent AARP survey, a shocking 71% responded that they didn’t pay any fees for their 401(k) mutual fund investments. I didn’t realize that Wall Street had suddenly earned a reputation for working pro bono. Well this simply isn’t the case, and investors need to better educate themselves on the cost of owning mutual funds which can be very reasonable (index funds) to exorbitant (load funds.)
The cost of owning a fund is called the expense ratio which covers the investment advisory fee, the administration costs, 12b-1 distribution fees and other operating expenses. I will not bore you with a breakdown of each expense but you should focus on the overall number. Today, the typical expense ratio for an actively managed mutual fund is about 1.5%. On the other hand, in the world of index funds, the expense ratio is typically around 0.25% and gets as low as 0.17% for the Vanguard 500 Index.
In my experience analyzing new client portfolios, mutual fund expense ratios often run as high as 4%. And many investors don't realize that this doesn't include the even bigger expense which is the sales load, aka the fee to the sales person. While many mutual funds have transitioned to no-load funds, an abuntant number of mutual funds still charge an exorbitant load fee. There are three types of loads: front-end load, back-end load and level load.
For simplicity, I will describe the front-end load. The day that your broker recommends a mutual fund and you authorize the purchase, you pay a sales fee, usually around 5% (the range can be between 3% and 8.5%.) This is an extraordinary fee. You immediately lose a big chunk of your investment no matter how long you hold it even it is for only one day! Interestingly, 7 of the biggest 15 mutual funds in terms of assets charge a front-end load. If you own any funds from the mutual fund company American Funds, you paid a sales commission and many charge 5.75% up front! If your broker moves you in and out of different mutual funds, you may want to ask how he is getting paid.
So how do you avoid this load fee? If you are working with an advisor, I recommend working with a fee-only advisor who doesn’t get paid on commissions. Would you want to go to a doctor who only gets paid by the pharmaceutical company for prescribing their medications? That is a huge conflict of interest.
If you own a mutual fund, do you know how much you are paying in expenses? Did you pay a load?
Header photo from Unsplash
By
