How Mutual Fund Expenses Hurt Shareholders

When the average investor buys $10,000 of Class A shares in a load mutual fund, how much of their money actually gets invested in the market?

If you thought it would be $10,000, you are not even close.

The way load mutual funds typically operate, by the time the average investor puts down $10,000 and leaves the investment rep’s office, only $9,450 will be invested in the market. The other $550 gets eaten up by sales charges which go to the selling broker-dealer and the fund distributor. In addition, another $50 typically is paid as an underwriting commission to the fund distributor.

(For a graphic of this process, see chart for a schematic of how these fees are charged to shareholders. Note: this chart has some ovals which are hard to read, but the first oval (farthest left) for Class A shares, says “Account $9,450.” The second oval says” $50 underwriting commission.” The third oval says “$500.")

That’s just for starters. Every year, the shareholder pays about 25 basis points (bps), or one-quarter of 1% in 12b-1 fees, plus a management fee of about 90 bps, plus a $20 administrative fee to the fund distributor.

The fee structures for Class B and Class C shares are different based on deferred sales charges, and higher initial investments. The common denominator in terms of fees for all these share classes is the 12b-1 fee and the administrative fee.

The Important Point
The key thing for shareholders to remember is that the 12b-1 fees are charged annually to shareholders by the fund distributor to primary pay for the mutual fund company’s sales and marketing efforts. The original stated goal of 12b-1 fees which was presented to regulators was to increase shareholder communications and boost fund assets which, in turn would lower fund expenses. That was the idealized version. Today, most fund companies, especially load companies, charge the 12b-1 fees to subsidize sales and marketing efforts, yet they rarely lower shareholder expenses. The higher the fund company’s expense ratio, the lower the shareholder’s total investment return.

The bottom line: 12b-1 fees are good for fund companies, and bad for shareholders.

In future posts, we'll look at how hidden revenue sharing agreements, shelf-space deals and other expenses which are not readily disclosed to shareholders erode returns.