Investors usually evaluate mutual funds based on performance results. Investors sometimes overlook how the costs associated with mutual funds can affect performance. Assuming two mutual funds are invested in the same securities, the lower cost fund will produce higher returns. Cost is a presently known factor that will affect future performance. Mutual fund costs can be classified as either transaction related or management related. Transaction based costs are associated with buying or selling shares of a mutual fund. Management based costs are ongoing expenses associated with owning a mutual fund.
Transaction based costs
Sales Loads are charges for buying or selling mutual fund shares, and are typically paid to the sales broker involved in the transaction. A Front End Sales Load is the cost of purchasing shares of a mutual fund. A person wanting to invest $1,000 in a mutual fund with a 5% sales load would pay $50 to the sales broker, leaving $950 to be invested the mutual fund. Mutual funds can charge up to 8.5% on a front end load. A Back End Sales Load is the cost of selling (redeeming) shares of a mutual fund. Back end loads can also be called Contingent Deferred Sales Loads. Back end loads are charged if the investor sells the shares within a certain number of years after purchase. The charged percentage usually lowers by 1% for each year the shares are owned until the load eventually drops to zero and disappears.
Some mutual funds charge fees for buying or selling shares. These fees are paid directly to the mutual fund rather than the broker and thus, are not considered a load. A Purchase Fee is charged when purchasing mutual fund shares and a Redemption Fee is charged when redeeming mutual fund shares. Fees are charged to cover the mutual fund's costs associated with the transaction, and sometimes charged to discourage frequent trading of mutual fund shares.
Management based costs
The Expense Ratio is the annual cost for a mutual fund to operate. The expense ratio is calculated by dividing the total annual operating costs for the mutual fund by the average total assets under management by the mutual fund. The expense ratio has three main components. The primary expense is to pay mutual fund managers for their investment advisory services, such as selecting which securities should be owned by the mutual fund. Other expenses for mutual funds are the administrative costs, such as mailing statements, maintaining account records, and providing customer service. Some mutual funds also charge 12b-1 fees for their advertising and marketing costs.
While all mutual funds have expense ratios, not all expense ratios are the same. Actively managed funds typically have higer expense ratios than passively managed index funds. The actively managed funds are more expensive because they are compensating the fund managers for their expertise in selecting appropriate holdings for the fund. Index funds own a set of securities represented by the index tracked and do not require as much evaluation for which investments to own. The easier management translates to a lower expense ratio.
No-Load Mutual Funds
Expense ratios are inevitable, but sales loads can be avoided. You can find plenty of good mutual funds that do not charge sales loads. Mutual funds without sales loads are called "no-load" mutual funds. Sales loads are justified as compensation to the broker for selecting a good mutual fund for the client. I do not believe a mutual fund with a sales load is a good selection for any client. Sales loads cost the investor more and do nothing to improve performance.
Theoretically, the lowest cost mutual funds are no-load index funds. These funds have low expense ratios and no sales loads. No-load index funds are good choices for investors who believe in efficient markets. They do not want to compensate sales brokers or fund managers for supposed "expertise" in selecting investments. Because of unpredictable conditions affecting future market performance, fund managers cannot consistantly pick the best securities over a long term. The most consistant way to produce above average returns is to minimize costs, and no-load index funds achieve that goal.
Sources: SEC, Investopedia, Motley Fool
