Mutual Fund Fees and Expenses explained: Front & back load Vs. 12b-1 charges. No Load Mutual funds.
Channel: Farhat Lectures. The # 1 CPA & Accounting Courses
Date: 2020-07-26

IN this recording, I discuss mutual fund fees and expenses.  Mutual fund fees generally fall into two big buckets: Annual fund operating expenses. Mutual fund fees and expenses are charges that may be incurred by investors who hold mutual funds.
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OPERATING EXPENSES Operating expenses are the costs incurred by the mutual fund in operating the portfolio, including administrative expenses and advisory fees paid to the investment manager. These expenses, usually expressed as a percentage of total assets under management, typically range from 0.2% to 1.5%. Shareholders do not receive an explicit bill for these operating expenses; however, the expenses periodically are deducted from the assets of the fund. Shareholders pay for these expenses through the reduced value of the portfolio.

The simple average of the expense ratio of all equity funds in the U.S. was 1.28% in 2016. But larger funds tend to have lower expense ratios (and investors place more of their assets in lower-cost funds), so the average expense ratio weighted by assets under management is considerably smaller, 0.63%. Not surprisingly, the average expense ratio of indexed funds (weighted by assets under management) is substantially lower, 0.09%, while that of actively managed funds is higher, 0.82%.

In addition to operating expenses, most funds assess fees to pay for marketing and distribution costs. These charges are used primarily to pay the brokers or financial advisers who sell the funds to the public. Investors can avoid these expenses by buying shares directly from the fund sponsor, but many investors are willing to incur these distribution fees in return for the advice they may receive from their broker.

FRONT-END LOAD A front-end load is a commission or sales charge paid when you purchase the shares. These charges, which are used primarily to pay the brokers who sell the funds, may not exceed 8.5%, but in practice they are rarely higher than 6%. Low-load funds have loads that range up to 3% of invested funds. No-load funds have no front-end sales charges. About half of all funds today (measured by assets) are no load. Loads effectively reduce the amount of money invested. For example, each $1,000 paid for a fund with a 6% load results in a sales charge of $60 and fund investment of only $940. You need cumulative returns of 6.4% of your net investment (60/940 = 0.064) just to break even.

BACK-END LOAD A back-end load is a redemption, or “exit,” fee incurred when you sell your shares. Typically, funds that impose back-end loads start them at 5% or 6% and reduce them by one percentage point for every year the funds are left invested. Thus, an exit fee that starts at 6% would fall to 4% by the start of your third year. These charges are known more formally as “contingent deferred sales loads.”

12b-1 CHARGES The Securities and Exchange Commission allows the managers of so-called 12b-1 funds to use fund assets to pay for distribution costs such as advertising, promotional literature including annual reports and prospectuses, and, most important, commissions paid to brokers who sell the fund to investors. These 12b-1 fees are named after the SEC rule that permits use of these plans. Funds may use annual 12b-1 charges instead of, or in addition to, front-end loads to generate the fees with which to pay brokers. As with operating expenses, investors are not explicitly billed for 12b-1 charges. Instead, the fees are deducted from the assets of the fund. Therefore, 12b-1 fees (if any) must be added to operating expenses to obtain the true annual expense ratio of the fund. The SEC requires all funds to include in the prospectus a consolidated expense table that summarizes all relevant fees. The 12b-1 fees are limited to 1% of a fund’s average net assets per year.2

12b-1 fees

Annual fees charged by a mutual fund to pay for marketing and distribution costs.

Many funds offer “classes,” which represent ownership in the same portfolio of securities, but with different combinations of fees. Typical Class A shares have front-end loads and a small 12b-1 fee, often around 0.25%. Class C shares rely more on 12b-1 fees. Class I shares are sold to institutional investors. These are sometimes called Class Y shares and carry no loads or 12b-1 fees.