Investing in mutual funds can be highly profitable, particularly over longer time horizons but, watch those costs! Not giving costs any attention is a fatal error on your part as they will make a profound impact on your short and long term returns.
What are mutual fund investment costs
There are a multitude of costs associated with investing and they will depend on the product you are interested in. The most common of mutual fund costs fall into two categories, transaction costs and ongoing costs.
Often referred to as transaction costs or brokerage commissions, whether you go direct to the mutual fund or through a broker they are incurred when you enter into the agreement to buy or sell the product. The costs range between products, brokers, method of purchase and the value of the investment parcel you are seeking. Buying direct, you can generally expect between 0.25% to 1.0% of the transaction value whereas, buying through a low-cost broker you can start anywhere from $14.95 for online trades, progressing to a percentage of the trade value, in some cases 0.11%.
Some mutual funds charge additional sales and marketing fees in the transaction process that are extremely damaging to your investment amount.
Front-end load – incurred in the purchasing process, this sales fee can be as much as 8.5% of the purchase amount, so a $10,000 purchase immediately reduces to $9,150.
Back-end load – typically starts at 5-7% at the time of purchase and reduces over a period of time, usually 5-10 years before coming to a zero value.
In addition to the fees incurred to buy or sell the security there are fees to manage the fund known as the operating costs or Expense Ratio. This ratio consists of:
Management fees – the cost to employ fund managers, this fee ranges from 0.5% to 1.0% of assets on average.
Administrative costs – everything to do with running the fund eg. printing, mailing, phone, internet, staff amenities, flights, accommodation, charter vehicles. Watch for the funds with high gloss annual reports with lots of high resolution graphics and colours, your paying for this!
12b-1 fee – an annual marketing and distribution fee that applies to US funds was originally introduced with the belief the expense would increase the customer base and dilute the expenses incurred by individual investors. This has yet to be proven and as it stands you are essentially paying for the fund to sell itself with no further return on your investment.
Why do investment costs matter
Simply put, costs subtract from your potential return and how great the impact will depend on the type of fund and how long you are exposed to the costs. Broadly speaking, a 1% increase in the overall cost profile of a fund over a 30 year time horizon could lower the final balance by 24%, a 2% increase could lower this further to a 41% decline off the base. To use a simple example, assume you invest $10,000 into a fund with an annual expense ratio of 0.07% (a figure achievable by some no-load low cost index funds) and an estimated average annual compound return of 10%. At the end of 30 years you could have an estimated $171,182 however, by raising the expense ratio from 0.07% to 2% the estimated accumulation would drop from $171,182 to $100,440, a 41% difference. And what was the cost of this management in dollars over the 30 year period? The 0.07% option resulted in an accumulated total management cost of $1,136 while the 2% presented $22,615, a staggering 1890% increase! Reason: The significant increase to the cost of holding this investment lowered the percentage of active money and subsequently reduced the powerful effect of compounding. Put another way, the increase in costs meant there was less money earning you interest over the investment period.