As a consumer, imagine if you were expected to buy an item without knowing the cost. In this case, most consumers would walk away from the retailer in disgust. Yet, millions of Americans who own mutual funds have no idea what the internal charges are for their investments. When it comes to the cost of your investments, ignorance is not bliss and knowledge is power. The stakes – your children’s college education or your retirement – are simply too high to allow inflated expenses to eat away at your return.
What Would You Choose?
Assume that you have to go to the grocery store to buy some oranges. Two stores offer very similar oranges at the same price. Store A charges $5 just to get into the store before you can buy the oranges. Store B allows you to walk in at no cost to buy the oranges. Any rational consumer would choose Store B over Store A. In the mutual fund industry, Store A is called a front-end load mutual fund and Store B is considered a no-load mutual fund. In this scenario, the correct choice seems obvious. However, investors on a daily basis are being charged front-end loads, back-end loads, and high internal expenses that are unnecessary and erode returns.
Front-end or Back-end Charges
The first type of charge that may be incurred is a front-end charge or a back-end charge. A front-end “loaded” mutual fund will charge a percentage, often 5%, off the top of a contribution. As an example, this leaves an investor who contributed $10,000 with a $9,500 investment in a mutual fund if a 5% front-end load was taken off the top. This means the investor has a smaller amount invested from the start. This makes it extremely difficult for an investor to make up the difference had they just used a no-load fund and invested the entire contribution into a similar fund. In contrast, a back-end charge is the fee a fund company may charge if an accumulation is moved out within a certain time frame. It often starts with a 5% penalty for withdrawing the fund the first year and gradually declines to 1% over a five-year period. Among other reasons, this prevents an investor from rebalancing or adjusting a portfolio for tax reasons. On the contrary, a no-load fund does not charge a front-end load or a back-end load. A prudent investor should never pay a front-end load or back-end load for investing in a mutual fund. There are thousands of no-load funds that offer similar or superior returns to loaded funds. When you look at purchasing a mutual fund the same as the grocery store example above, it makes perfect sense to purchase the fund with no front-end or back-end charge.
Internal Expense Ratio
The second charge that you may incur is an annual expense. This is sometimes called an internal expense ratio. Both loaded and no-load funds charge an annual expense. However, the annual expense can vary widely from .10% to 2%. Would you pay 20 times more for oranges? These expenses can be found in the prospectus of the fund and may be hard to find. Keeping with the grocery store example above, this would be similar to paying less for oranges in one grocery store compared to another. The less you pay at the grocery store for oranges, the more money you are left with in your pocket. Investing in mutual funds with a low internal expense ratio will lead to higher accumulations than a similar fund that has higher charges. Many companies offer no-load mutual funds with low internal expenses.
The third charge that you may incur is a maintenance charge. These are the irritating small deductions that you may see on a quarterly statement. Maintenance charges typically vary from $10 to $100 annually. These charges can be hard to avoid if you have a small balance, but not impossible. It is important to be aware and notice these charges because they can add up and reduce your overall accumulation.
Fees Erode Your Accumulation
It is extremely important for investors and advisors alike to be aware of the hidden costs associated with mutual funds, exchange-traded funds, and annuities. Those who are not, are throwing money away while planning for some of the most important events of their lives.